#inflation

Inflation is always and everywhere a monetary phenomenon

By:  Michael Allbee, CFP® Principal| Senior Portfolio Manager

The past few months saw some eye-popping inflation readings after subdued inflation prints last year due to COVID. The Core Consumer Price Index (“CPI”), which excludes the volatile energy and food categories, rose 0.9% in June after increasing 0.7% in May and 0.9% in April, bringing the year-over-year reading to 4.5%. Headline CPI, which includes energy and food, rose to 5.4% year-over-year for the largest 12-month increase since August 2008.

A confluence of events drove these inflation outbursts: 1) the year-over-year inflation readings were expected to jump during the summer due to the low readings a year ago, 2) the speedy rollout of widespread COVID-19 vaccinations in the U.S. and fiscal stimulus unleashed pent-up demand faster than expected, catching many businesses off-guard, 3) the flow of goods ordered from overseas was slowed by shipping bottlenecks including the six-day blockage of the Suez Canal, 4) staffing issues are a contributing factor in the shortages, and 5) other one-off supply constraints (i.e., ransomware attack on a U.S. fuel pipeline, a brutal winter storm knocked out the power grid in Texas, and a global shortage of semiconductors).

Many economists (including those at the Federal Reserve) expect many of these price hikes to be short-lived (“transitory”) as output increases to reduce the bottlenecks.  In fact, roughly 90% of the CPI increase was accounted for by reopening price rebounds and supply disruptions. By far the largest contributor to the price rise in that category (accounting for over a third of the increase in the headline CPI) was used car purchases as new car sales were disrupted chip shortages. The other large contributor was transportation services, chiefly airline ticket sales. All the other categories (core services) barely budged. Despite three monthly increases, the 12-month increase in the shelter component, which constitutes nearly a third of the overall index, is still just 2.6%.

And add to this that as the supply constraints ease, year-over-year comparisons to the abnormal pandemic era are subsiding (May 2020 marked the pandemic low in the price index), the $300 federal enhanced unemployment benefit is expiring (many states have already ended it), many employers are re-opening offices, and school will soon be back in session.

However, while inflation might prove to be transitory, the longer-term path of inflation is still unclear and could depend on economic policy decisions yet to be made. Consider this. Inflation has been rising since last June, and yet the Fed has not changed policy one iota. It has been running monetary policy full steam ahead during rising inflationary pressures. Adjusting for inflation, monetary policy has become easier as the real Fed Funds rate (adjusted for inflation) has fallen from -1.1% to -4.4%. This is the result of their new policy framework not to raise interest rates preemptively but to seek maximum employment and deal with inflation later.

Given that “inflation is always and everywhere a monetary phenomenon” as famously said by Nobel laureate Milton Friedman, our goal as your advisor is to construct a risk-appropriate portfolio that will withstand any one of numerous economic scenarios that may unfold, including a scenario of high inflation.

One of my favorite quotes is attributed to Roman philosopher Seneca: “Luck is what happens when preparation meets opportunity.” At BFSG, we had already prepared our portfolio for an inflation scenario before coming into this year by reducing our exposure to long-term bonds, holding Treasury Inflation-Protected Securities (TIPS), initiating and adding to our gold position, holding international stocks denominated in foreign currencies, and having discussions with clients to reduce exorbitantly large cash reserves in low yielding savings accounts. We believe we will have an opportunity as inflation subsides over the next year to build these positions further and possibly add other real assets (i.e., real estate, natural resources, etc.). We believe our portfolios are prepared to meet the opportunity to enable our clients to withstand inflation and other challenges that will inevitably come our way.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s web site or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please see important disclosure information here.

Why the Markets Ignored the Fed

By:  Thomas Steffanci, PhD, Senior Portfolio Manager

On Wednesday, June 23, 2021, the minutes of the Federal Reserve’s (the Fed) latest policy meeting held a week earlier were released along with individual members’ (anonymous) estimates of where the Federal funds rate will be through 2024. The policy setting group (the Federal Open Market Committee) is comprised of 18 members including Chairman Jerome Powell.

The content of the minutes was a “stunner” according to market pundits. Of the 18 Fed officials, 13 estimated that the Fed would likely raise interest rates twice by late 2023, up from 7 members in March. And seven of those 13 members expect interest rates to rise next year vs. three in March.

Why the shift? The committee’s average estimate of annual inflation in 2021 was increased from 2.4% to 3.4%. This may not sound like a big deal, but it assumes that inflation is going to run hotter in the remaining months of this year than formerly expected. Undoubtedly, the latest surprising May inflation number of 5% compared to a year ago turned the Fed heads’ March projections to dust for the ensuing 3 years.

The market was caught off guard by these changes. The 10-year Treasury bond yield leapt from 1.48% to 1.60% immediately following the release, and the Dow Jones Industrial Average (the Dow) lost about 300 points and closed lower the next two days. But bond yields wound up getting back to where they were during that two-day period before all this happened. Putting a capstone on this, the Dow is up 3% from its low post-Fed level.

So, the “stunner-in-the-summer” turned out not to be. There have been various reasons given for this. One has it that Chairman Powell harnessed a few fellow members to argue publicly that these estimates are individual member projections which in the past turned out to be wide of the mark. Another was that the committee did not discuss the timing of “tapering” their purchases of Treasury and mortgage securities or the extent of any interest rate changes.

But the markets’ ultimate reaction was more fact-based than that. The Fed’s latest meeting utterances were not “hawkish” at all. Consider this. Inflation has been rising since last June, and yet the Fed has not changed policy one iota. It has been running monetary policy full steam ahead during rising inflationary pressures. Adjusting for inflation, monetary policy has become easier as the real Fed funds rate has fallen from -1.1% to -3.8%. This is the result of their new policy framework not to raise interest rates preemptively but to seek maximum employment and deal with inflation later.

So, appearing to be hawkish to Wall Street know-it-alls, under their new framework the Fed is not going to get ahead of the curve to stem inflation. Even those on the committee who see a higher Fed Funds rate in 2022 are only penciling in a .75% level, a mere half percent higher than the upper Fed range now.

The Federal Reserve told the world and importantly the stock and bond markets that they expect to maintain a negative Fed funds rate for at least the next 2½ years. With the real cost of money an enticingly negative 4% or more, why should the markets give any credence to what the Fed says otherwise? Pay attention to what they do and ignore the rest. That is what the market understood this week.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s web site or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please see important disclosure information here.

The Inflation Dog Didn’t Hunt in April

CPI Treemap: Area Represents Weight in Index, Color Represents % Change Year-Over-Year (Source: Payden&Rygel)

By:  Thomas Steffanci, PhD, Benefit Financial Services Group

The past two weeks saw some eye-popping inflation readings. The consumer price index (CPI) for April came in at 4.2% year-over-year (YoY), but a surprisingly large 0.8% month-over-month (MoM) gain. The producer price index (PPI) was also hot, coming in at 6.2% YoY and 0.6% MoM.1

The Federal Reserve has been telling anyone who would listen for the past several months that transitory inflation outbursts were to be expected, caused by pent-up demand, relaxed Covid restrictions, the stimulus, and temporary supply constraints. These would not move the Fed to begin to withdraw their liquidity provisions to the economy, as employment was still far below its pre-pandemic level.  Several Fed speakers went on record with saying as much…and again after the inflation reports.

But to listen to Wall Street, these numbers will pull the Fed forward in their timetable to begin to withdraw their support by reducing their purchases of Treasury and mortgage securities. For years, Wall Street has had an imbedded ‘recency bias’, meaning giving the most importance to the most recent event. So, you would have thought that market prices of stocks and bond yields would have reacted to the these “shocking” readings by reacting negatively as horns blew and whistles sounded.

Well, that is not what has happened. The futures markets for bonds and Treasury bills barely fluttered. More importantly, stocks and bonds in the cash market reacted positively since the May 12 inflation news. Ten- and 30-year bond rates have fallen 10 basis points since then. And the Nasdaq gained 4.8%, and the S&P 500 has risen by 3.4%.2,3

So why did this happen? As always, the devil was in the details which are frequently ignored by the headline grabbing talking heads. Goldman Sachs in a recent report went behind the numbers to ferret out the details. Here’s what they found:  90% of the CPI increase was accounted for by reopening price rebounds and supply disruptions. By far the largest contributor to the price rise in that category was used car purchases as new car sales were disrupted by parts shortages. The other large contributor was transportation services, chiefly airline ticket sales. All the other categories (core services) barely budged. And add to this that the year-to-year comparison period was March 2020 where prices actually fell, so you have a distorted picture of the importance of the April CPI.

What do we take away from all this? Two things. The market saw through the fog of the headline inflation numbers so don’t listen to the noise of the moment. And second, all this tells us is that the market…maybe…just maybe…is starting to believe the Fed when they say they will continue asset purchases for “some time” and that liftoff for the Fed Funds rate will not start until the second half of 2023. Of course, several like-sized increases like April’s during the next six months could move the needle closer. But not now.

  1. Source: www.bls.gov
  2. The S&P 500 is designed to be a leading indicator of U.S. equities and is commonly used as a proxy for the U.S. stock market.
  3. Source: Morningstar.com

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s web site or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please see important disclosure information here.

The Fed’s Switcheroo

The U-6 Unemployment Rate Bottoms Have Been “Stuck” Around 7 – 7 1/2% Around Cyclical Turning Points

It is readily apparent that the Federal Reserve (the “Fed”) is more focused on employment rather than inflation. Last year the Fed released a new policy framework (1) that included a shift away from its traditional practice of raising interest rates based on the headline unemployment rate (U-3). It used to be that the market was trained to expect rate increases being triggered by the achievement of full or maximum employment, a level below which economists generally think inflation bubbles up in true Phillips Curve fashion. (2)

In Fed Chairman Jerome Powell’s appearance before the Senate Finance Committee last week he expanded on the Fed’s employment objective to what he called a “broad-based and inclusive goal,” where officials consider the unemployment rate of minorities as well as workers who are more marginally attached to the labor market. (3)

So, investors should no longer be focused on the “official” rate of unemployment, the U-3 rate. Instead, the Fed appears to be more concerned with the U-6 rate, which stands at 11.1% (versus a 6.2% U-3 rate). The African American unemployment rate, meanwhile, is 9.9%, while the Hispanic unemployment rate is 8.5%.(4) How the Fed is weighing these measures and where it wants them to be is unclear, as discussions have been qualitative not quantitative.

But it does dovetail with the Fed’s “patient” attitude towards inflation. The U-6 unemployment rate is historically “sticky” on the downside as skills training for marginal and disadvantaged workers takes time before meaningful employment occurs (see the chart above). It remains a huge policy question whether “structural” unemployment can be remedied by monetary policy. We have our doubts and keeps us very uneasy about the Fed’s response to cyclical inflation with their reaction function geared to the U-6.

  1. See Federal Open Market Committee (2020b, 2020e, 2020f).
  2. The Phillips curve is an economic concept developed by A. W. Phillips stating that inflation and unemployment have a stable and inverse relationship. The theory claims that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment. Read more here about the relevance of the Phillips curve to modern economies.
  3. The Bureau of Labor Statistics (BLS) defines marginally attached workers as persons who are not in the labor force, want and are available for work, and had looked for a job sometime in the prior 12 months. They are not counted as unemployed because they had not searched for work in the prior 4 weeks, for any reason whatsoever. The marginally attached are a group that includes discouraged workers.
  4. Source: BLS, Civilian Unemployment Rate (https://www.bls.gov/charts/employment-situation/civilian-unemployment-rate.htm#)

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s web site or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please see important disclosure information here.