Inflationary pressures are high and have been for the past year. Misguided monetary and fiscal policies, COVID-19, supply chain issues, tight labor markets, and the war in the Ukraine have contributed to systemic inflationary pressures that haven’t been seen in decades. The year-over-year change for the Consumer Price Index was 8.6% in May according to the Bureau of Labor Statistics, a level last reached in the early 1980s.
The Federal Reserve must raise interest rates aggressively. In our opinion, it is too late for gradualism. It would probably be wise to raise rates one percent at their upcoming meeting so that people and investors know the Fed is serious about fighting inflation. The Fed also needs to shrink its balance sheet, another way in which to slow demand. There has not been a good explanation for why quantitative easing lasted for so long after inflationary pressures appeared.
Easy fiscal policy has also contributed to inflation. Massive budget deficits and COVID-related stimuli above wage losses lit a fire under the consumer. A huge amount of money was put in consumers’ pockets to spend when many of their normal spending outlets were closed due to the pandemic. Fortunately, now the reverse is occurring, and budget deficits are falling rapidly.
COVID-19 led to massive economic dislocations that are still reverberating. It contributed to the reduction in labor supply and the bottlenecks that have slammed supply chains. With consumers unable to and/or unwilling to spend on services, supply and demand imbalances ensued for many goods. As supply chains normalize, the hope is that goods inflation will abate and reverse in some places to cool inflation. This has started to happen for some durable goods. Several large retailers disclosed excess inventories and announced price cuts to reduce inventories.
Stretched global supply chains have improved. The inventory to sales ratio has risen, although it remains at a low level, while shipping costs are falling. The global supply chain is not healed, but it has improved modestly. Continued improvement is needed to bring inflation down.
A tight labor market has added to inflationary pressures. Here the evidence for future inflation is mixed. The labor supply is growing as people reenter the labor force, yet the ratio of jobs available to job seekers remains near an all-time high. Some indicators suggest that the demand for labor is weakening with wage gains moderating. Weekly unemployment claims are ticking higher, while large companies such as Amazon indicate that they now have too many workers after recent complaints about not being able to fill positions. The labor market is not yet soft, but there are signs that it is less tight.
Oil and food prices must come down or at the very least stabilize for inflation to approach the two percent target. At some point this will happen, but there are few signs that they have peaked. There are other factors, but the Russian invasion of the Ukraine made a quick price reversal unlikely, especially in countries that depend on Russia or the Ukraine for energy and/or food. It will take time to replace the food and energy supplies produced there.
There is some hope that broad inflationary pressures have peaked. The housing market is starting to slow, but prices and owners’ equivalent rent are still rising at an uncomfortable level. On the other hand, lumber prices are now at a about a third of their May 7th, 2021, peak. The hope is that if the spike was a harbinger for higher prices, then the reversal of most of the post-lockdown price gains is foreshadowing slowing house price gains and lower rent increases. Automobile prices may have peaked. Inventories are still extremely tight but have risen from COVID-lows. Some durable goods are starting to see price deflation. Many retailers overordered while consumer preferences switched to services. A moderation in housing and auto prices is needed to help lower inflation.
It is going to be very hard for the Federal Reserve to get inflation levels to its two percent target. There are certain factors working in their favor. Lower money supply growth and reduced deficits should help moving forward. Improving supply chains and falling durable goods prices are sustainable barring another COVID-19 wave resulting in lockdowns. Housing prices and labor markets seem to hold the key in bringing inflation down materially. If early indicators of normalizing conditions hold, moderating housing price increases and normalized wage gains can lower inflation readings. Even if this happens, NPP thinks lower energy and food prices are required to get inflation to the two percent target. We think this is unlikely to happen in the immediate future. Inflation could fall to three percent or maybe two and a half percent with rising commodity prices, but two percent is unlikely.
The inability of inflation to moderate has surprised most market watchers and has increased the chance of a recession as the Fed reacts to get it under control. Whether that is priced into markets remains to be seen. Our belief is that a mild recession like the Gulf War recession has mostly been priced into equity markets. The main risk is that inflation does not come down in the coming months requiring the Federal Reserve to raise rates to four percent or higher. If that is what is required to tame inflation, then markets have more room to fall. It doesn’t mean this isn’t a good entry point for long-term investors. We think it is, but markets are sure to be choppy until there is concrete evidence that inflation is moderating.