Today we received the January update on the Consumer Price Index (CPI), which indicated that inflation metrics have broadened out, and now encompass most segments of the CPI and PCE series. Last summer, sectors that were most sensitive to the reopening of the economy and an easing of travel restrictions were driving higher inflation. Those sectors included used car prices, hotels, lodging, gasoline, and restaurants. Today we are experiencing an elevated rate of inflation at both the headline CPI level (Year over Year +7.5% - a four decade high) and at the Core level (Year over Year +6.0%) which excludes food and energy.
Despite the wishful labeling of inflation as “transitory,” economy-wide inflation indicators are not abating. Energy prices have risen, with West Texas Intermediate Crude topping $90/barrel recently – though further increases would likely require a geopolitical event (possible) or a very slow pace of supply increases from OPEC+ (unlikely). After declining this fall, lumber prices are rising again. Though they have recently plateaued, median home prices are up just under 20% year-over-year according the S&P Case Shiller Index. The shelter component of CPI is now running above 4% and is expected to ascend further.
The Invisible Thief
Anyone who’s been to the grocery store lately is likely familiar with limited supplies in certain categories and generally higher prices. The prices of many retail items, including clothing and electronics, are being affected by transportation bottlenecks, as well as worker shortages, and higher input/material costs. In industries with acute worker shortages, salaries and bonuses have increased to pull marginal workers back into the workforce. Whether these increases become entrenched is yet unknown, but it seems possible that the increases will stick, even if large raises are not repeated annually going forward. For many workers, higher inflation is eating into real income, creating an aggravating pressure point. Will companies allow higher labor costs to cut into wide profit margins, or will they raise prices to protect their bottom line? The answer to that question remains unknown, and will likely vary from industry to industry.
A Break in the Clouds
The onset of an inflationary psychology is particularly damaging, and from studies of past episodes, can be extremely difficult to reverse once it takes hold. We are evaluating inflation from a variety of angles to separate fact from fear. While far from certain, we see reasons to believe that goods inflation may crest later this year. One sign is the rollover in the Institute of Supply Management’s Prices Paid Index, which is down from 92 last summer to 76 in January. The series tends to lead the CPI index by around 6 months, indicating that a fading of consumer goods inflation later this year is possible. In the 4th quarter, U.S. GDP was bolstered by a strong inventory build, as businesses sought to replenish a depleted stock of finished goods, to be better prepared for future demand. A more balanced inventory-to-sales environment would presumably stabilize prices that were elevated on account of shortages.
Finally, the sharp decline in COVID hospitalizations from the recent spike is a hopeful indication that a less severe/endemic phase is at hand. This outcome would be a game changer, and would help shake loose many of the supply chain and labor market constraints that played a role in higher prices last year.
Adding to this sanguine list, longer term interest rates do not appear to be factoring in an extended period of high inflation (3-5%). The 10-year U.S. Treasury yield has moved from 1.51% at the time of our last our inflation article on October 14th to 2.0% today. This relatively modest move in rates doesn’t suggest that a resetting of inflation expectation to higher levels is occurring. Additionally, market-based inflation hedges have persistently indicated expected 5-yr forward inflation in a 2.0-2.5% range. These “canaries in the coal mine” are not perfect, and can change rapidly, but they do give us a broader perspective of prevailing attitudes.
The Federal Reserve to the Rescue
Though they’ve been accused of being late to act, the Federal Reserve’s Federal Open Market Committee (FOMC) has begun to normalize monetary policy, reducing monthly bond purchases that have inflated the Fed’s balance sheet to over $8 Trillion. Net bond purchases are scheduled to cease by the end of the first quarter, coincident with plans to raise the Federal Funds rate from its current 0.00%-0.25% range, which has been in place since March 2020.
Soon the Fed will embark on a double-barreled approach to addressing inflation: Raising rates and shrinking its balance sheet through run-off. The pace of these moves is yet unknown, and will be dynamic. The Fed’s December projection has core inflation averaging 2.2%-3.0% this year and falling to 2.1%-2.4% next year (2023), which seems optimistic in our view, especially given the Fed’s desire to move interest rates higher in a gradual manner. With a bit of luck the Fed seeks to move short-term interest rates to higher levels more appropriate for a fully employed economy, at the same time improved supply chain logistics provide some relief for consumer goods price inflation later this year.
History indicates that fine-tuning monetary policy is an elusive goal and often subject to operational error that can potentially destabilize the economy. Nevertheless, we view it as a clearly positive development that the FOMC is now engaged in moving toward more appropriate liquidity conditions.
We Can Help
Evolving inflation expectations remains high on the list of factors that we are monitoring at this time. Investing during periods of transition can be challenging, with amplified volatility creating both opportunities and pitfalls. Separating the noise from the trend involves utilizing a diligent and robust process for assessing inputs, forecasting trends, and understanding history. The Hancock Whitney Asset Management team is deeply engaged in the process and here to help assess your financial needs.
Source: Bloomberg
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