Lately we have been getting similar questions from clients regarding interest rates and inflation. Below are our abbreviated responses to these questions but please contact us if you would like to have a deeper discussion on these or any other subjects.
1) What is your outlook for interest rates? Will the Federal Reserve be able to maintain low rates for the foreseeable future?
The Federal Reserve can control rates on the short end of the yield curve and they currently intend to keep the federal funds rate rates near zero through mid-2023. Their outlook could change, and most investors believe the Fed will have to start moving off the zero bound sometime next year. Nonetheless, the Federal Reserve is unlikely to consider raising rates until unemployment reaches the very low levels seen in 2019. In addition, they are willing to accept much higher levels of inflation than we have seen over the last decade before raising rates. While runaway inflation could cause the Fed to raise rates before “full employment” is reached, we don’t believe that sustainably high inflation is going to happen. The high current readings for inflation are being distorted by the depressed levels from a year ago (see chart).
The chart above shows the rolling seventeen-month cumulative change in the U.S. consumer price index. The most recent inflation reading is for May 2021. The most recent seventeen-month interval measures inflation from December 2019 to May 2021, and shows a cumulative increase of 4.01%, which equates to 2.81% on an annualized basis. The short-term inflation readings are scary and give us pause, but if you look at the longer-term trend it doesn’t seem as bad. NPP expects a few more months of higher readings before inflation readings normalize at lower levels. We will continue to monitor the data to see if our thesis plays out, but if current inflation levels are transitory, rates can remain lower for longer.
2) The money supply has expanded in ways never seen before in this country. The total quantity of goods and services isn't keeping up with monetary growth and this helicopter money isn't all going towards productive investments. The total volume of money is increasing faster than the growth in goods and services, which should lead to price inflation. How will we avoid much higher inflation?
Despite the expansion of the monetary supply, there are reasons why it has not created massive price inflation so far. One is that consumers are not spending a large percentage of the stimulus. Whether they are scarred from the late-1990s tech and housing/credit bubbles, scared because of COVID, or just do not have a spending outlet, a huge amount of the stimulus is being saved and/or used to pay down consumer debt. Thus, a fair amount of the stimulus has not gone into the real economy. Another reason centers arounds the velocity of money which measures how often money changes hands. Fisher’s Quantity Theory of Money states that P =MV/T where P=price, M=money supply, V=the velocity of money, and T = volume of transactions. We believe that more debt leads to slower growth and less inflation in developed economies, not more, and a less dynamic economy. We do not know if we are correct about the cause of the drop in velocity, but whether we are is not the point. Velocity has been falling for decades and has collapsed coincident with the expansion of the money supply (see chart).
NPP thinks inflation will be elevated in the coming months, but we are not convinced it will stay that way without permanent government intervention at elevated levels. However, we should note that our conviction is not high, and we think the probability of higher inflation has risen. We are not a fan of the Federal Reserve’s policies nor the spending policies because we do not think emergency conditions are still warranted. Nevertheless, we lean toward inflation being a short-term phenomenon.