Inflation: How Did It Happen?? We Did It!!

Inflation: How Did It Happen?? We Did It!!

An economy that was struggling with deflationary tendencies for over a decade and a Central Bank unable to hit its 2% target find themselves in the middle of a surge in prices (inflation). The long-term structural reasons for containing price increases (i.e. demographics, technology, globalization, etc.) provided the reason for the Fed to change how it implemented policy. As we have discussed numerous times, the “failure of their forecasts” moved the central bank to change its model and focus more upon actual results rather than forecasted outcomes to set policy within the context of the dual mandate – price stability and full employment. Full employment is now being redefined as maximum employment – a disaggregated approach – minority unemployment, etc.

The government’s response to the COVID-19 virus severely damaged the infrastructure of our economy. The shutting down of businesses with little regard for the consequences on mainstream America disrupted and destroyed parts of the supply chain, caused massive dislocations in the employment base, damaged the social fabric of our country, and placed our children at a serious disadvantage. We have yet to see the full impact of delayed healthcare treatments and testing, as well as the surge in addictions. Poorly prepared public figures, a poorly prepared healthcare system, and an insufficient knowledge base on COVID-19 created many mis-directions, a plethora of misinformation, and an abundance of fear.

The public policy response to the crisis – fiscal and monetary – provided the funds and the liquidity for the restoration of business activity. These actions coupled with the success of the vaccination program and the reopening phase set the stage for a resurgence of “demand” – a resurgence at the time of supply limitations and a disjointed supply chain. Demand chasing limited supply has caused a spike in prices and is likely to cause price volatility for several more months. In some cases, a return to “normal” production and supply chain could easily take us into next year.

As pundits, media heads, and many market participants focus on near-term inflation data and excoriate the Fed for failing to recognize the seriousness of the problem, little is being added to our understanding of the underlying problem and how to deal with it. Exogenous shocks to the economic system like the 2020 pandemic and the 1970s Arab oil embargo, disrupt and distort the natural economic order. I was there in the 1970s and saw the impact of the lack of oil supply and the price disruptions. It was devastating to many parts of the U.S. The Northeast experienced a severe recession and New York was on the brink of bankruptcy, while the Southwest flourished as oil prices soared.

The mistake that was made by the Fed during that period was the way they responded to the surge in inflation due to the quadrupling of the price of oil. Empirical research suggests that the Fed’s tightening actions in response to inflation only exacerbated the problem. Former Fed Chair Ben Bernanke made that point on numerous occasions, including in academic research papers.

Given the historical framework, the monetary authorities are likely to continue maintaining the current policy stance – buying $120 billion of securities per month and holding the federal funds rate between 0 – 0.25% for some time. The surge in employment that is likely to occur in May is expected, particularly in light of a weak April and the reopening of the economy. Moreover, further sizable gains are likely over the summer as the supply chain is being repaired.

It should not be surprising if the discussion of “tapering” bond purchases is discussed in earnest at the June 16th FOMC meeting. However, that meeting is likely to be the beginning of a process of communicating to the markets the Fed’s intention. Most importantly, no action is likely for some time.

Many factors that are still unknown both in terms of timing and magnitude will influence the economy. So-called infrastructure proposals are working their way through the Halls of Congress, but the dollar amount and mix is still to be determined. Moreover, progress with vaccinations is going well but the fall (the home of new viruses) may be another story.

It is important to recognize that inflation is the “state of rising prices.” If prices rise (spike) due to market distortions but stop increasing, then there is no inflation. The mistake would be if the Federal Reserve moved too soon when many elements of the supply chain are still disconnected. Although there would be dire employment consequences, the monetary authorities can certainly squelch demand-induced inflation. However, they can’t do much about supply-engendered price hikes, which we are experiencing now.

It is not unreasonable to expect that the highly stimulative policies will lead to higher inflation in the longer run. However, the confluence of forces (domestic and international) would suggest patience at this time appears warranted. From the market’s perspective, inflation, tapering, COVID-19, infrastructure spending, and taxes are constantly being discussed and discounted in one way or another by investors.

With all these concerns there has been limited adverse reaction in the bond market. The 10-year U.S. Treasury bond hovers around 1.6% and strong earnings growth is being experienced by many companies with many favorable price responses. Yet, investor sentiment is subdued. According to the American Association of Individual Investors, bullish sentiment fell to 36% for the week of May 27th. It stood at 56.9% on April 8. This is a contrary indicator. At the same time, trillions of dollars reside in money market funds – ultimately a source of market firepower. Currently one- and two-month treasuries offer no return, while $120 billion a month of liquidity is being added to the financial system.

A tug-of-war exists between fear and fundamentals. Navigating the sentiment shifts are seldom smooth. It is certainly true that pockets of speculation exist. SPACs, cryptocurrencies, and companies selling at extreme multiples of revenues with no earnings, create volatility and are cause for concern. However, periodically the market has removed some of the excesses as consolidation has taken place. In the end, fundamentals win out. Earnings power and liquidity are strong long-term ingredients for higher valuations.

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