Inflation is taxation without legislation.
-Milton Friedman

There are times when macro concerns dictate most of the market action. We are in the midst of one of those periods. Indeed, financial markets have remained under significant pressure with many investors glued to each inflation print in an attempt to gauge future Federal Reserve policy moves. The concern: Stubbornly high inflation could prompt further aggressive interest rate hikes, knocking the economy into recession.

Over time, inflation erodes purchasing power, disproportionately impacting lower-income households. It also squeezes businesses as they confront higher costs that must either be absorbed or passed on. Meanwhile, lenders are disadvantaged — those future principal payments do not buy as much as the original dollars lent — so long-term interest rates shift upward to compensate. Borrowers end up paying the price. And once inflation becomes entrenched, it tends to be self-perpetuating.

Hydra reappears

Prior to the pandemic era, broad-based inflation had been an increasingly distant image in our rearview mirrors. The U.S. economy and financial markets have benefited mightily from a long disinflationary trend of moderating price increases after Paul Volcker’s Fed slayed the beast four decades ago. Starting last fall, however, consumer price inflation reared its head, persisting at rates not seen since the early 1980s.

Yet the current inflationary shock is not one from the textbooks. The pandemic (which abruptly shut down or otherwise hampered global production) and ensuing fiscal response (which propped up incomes and spending) unleashed a series of imbalances that led to price pressures across industries. After being locked down, consumers sharply redirected spending from services to goods at the same time supply constraints and shipping bottlenecks curtailed the latter’s availability. Later, as society reopened and the demand for services resumed, labor shortages prevented many businesses from returning to prior capacity levels.

Supply chains have become less tangled, but overall inflation has broadened, increasingly driven by the services sector, rather than by a mismatch of supply and demand in goods. The tight labor market has led to rising wages which account for a greater share of total costs for service businesses.

Compounding errors?

The headline CPI rate has exceeded 8% for seven straight months. Excluding food and energy prices, the core rate has hovered around 6% for the past nine. Initially underestimating the inflation threat, Fed policymakers were tardy in applying the brakes. St. Louis Fed President James Bullard had argued that the board needed to “front-load” their tightening. They are playing catch-up. The central bank has hiked short-term rates five times this year, moving the fed funds rate from near zero to a 3.00-3.25% target range. This marks the fastest pace of rate hikes in 40 years and the cycle is not over.

Today, some observers argue that the bank is making the opposite error, moving much too aggressively to slow the economy. We’ll only know with hindsight. But since the beginning of the year, the 2-year Treasury yield has risen from 0.7% to 4.4%; the 10-year, from 1.5% to 3.9%. And gross domestic product contracted modestly during the first two quarters.

A variety of indicators suggest that inflation will actually begin to decline in the coming months. Although volatile, gasoline and food prices have both been trending lower, as have many commodity prices. Shelter prices — a key source of overall inflation (and accounting for 40% of core CPI weight) — will stay elevated for a while but Zillow’s surveys indicate that rent increases are moderating. Meanwhile, shipping costs and other measures of supply chain bottlenecks have eased. For example, transporting a 40-foot freight container from Shanghai to Los Angeles costs $3,000 today, down from over $12,000 in 2021.

Tighter for longer

The central bank wants to avoid a wage-price spiral but there are signs that wage growth will decelerate. The wage level tends to move with job openings which have been falling in recent months. However, even if the inflation rate were to recede in the near future, will it do so quickly enough to mollify the Federal Reserve? The bank seems likely to maintain course until convinced that inflation is falling broadly.

While trying to slay inflation without eviscerating the economy, the Fed faces two complicating issues. First, policymakers do not control many of the factors propelling inflation. It cannot find more oil, produce more cars, recruit more restaurant workers, build more apartments, or remove the Russian despot. To quell inflation, central bankers will have to push hard on the demand side, driving it down. Moreover, monetary policy changes tend to work with fairly long lags (6-18 months) before the impact is obvious. Therefore, by waiting until inflation drops considerably for a protracted period to time, the Fed will necessarily over-tighten.

Critically, the Federal Reserve retains the inflation-fighting credibility established years ago by Paul Volcker. Surveys indicate that consumers still expect long-term inflation to remain at reasonable levels; bond market measures send a similar message.

Buyer’s remorse

The interest-rate sensitive housing sector has borne the brunt of the Fed’s abrupt U-turn. By early October, the rate on a 30-year conforming mortgage had reached 6.8%, more than double the sub-3% rates of 2021. For a new $350,000 mortgage, a $1,400 monthly payment (principal and interest) has morphed into a $2,300 obligation.

Not surprisingly, the Mortgage Bankers Association recently indicated that applications for new mortgages had fallen 40% to the lowest level in seven years. Refinancing activity has collapsed. Through August, existing home sales had dropped for seven consecutive months, the last three seeing double-digit declines. Redfin continues to report that homes for sale are sitting on the market longer with fewer sold above the listing price. The median home price has still risen over the year.

Firmer footing

Fortunately, the current backdrop suggests that a Fed-induced recession would be shallow rather than deep. First, the labor market is relatively strong. There are still more open jobs than workers to fill them (1.8 openings per unemployed worker). As businesses scale back staffing in response to lower demand, this gap could absorb some of the corresponding job losses without causing a large uptick in unemployment.

Second, households and businesses are generally on solid financial footing. Bank deposits stand $2.5 trillion (representing 10.5% of GDP) above their pre-pandemic trend. The strength of private-sector balance sheets should mitigate some of the hit to incomes from a recession. Importantly, a well-capitalized banking sector appears positioned to absorb credit losses without imploding as in 2008-09.

Third, pent-up demand should help support growth. A number of consumer industries, notably in the service sector, have room to expand, merely to return to normal levels (e.g., travel, restaurants). On the manufacturing side, two decades of underinvestment in capital equipment plus a shift toward more domestic production should necessitate a capex upgrade cycle.

Fourth, while the housing sector will certainly be pressured, there is no glut of unoccupied homes, unlike the mid-2000’s experience. During the current expansion, new construction has failed to keep up with household formation. So the vacancy rate is less than 1%. Also, homeowners have not used residences as ATMs, extracting their equity to support other spending, as many did prior to the last downturn.

Driving forward

As markets sputter, the main street economy is holding up better than headlines may suggest. However, we expect the capricious market action to continue until there is more clarity on Fed policy — and on the interplay between inflation, interest rates, and economic growth. Investing (and sticking by one’s investments) is no easy task during periods of rapid change, disconcerting headlines, and sharp market swings. Nevertheless, the resilience of the U.S. economy will drive growth over time.

 

Christopher J. Singleton, CFA, Managing Director

October, 2022