From leading indicators to business surveys to initial unemployment claims, the economic message is clear: The 2020 COVID-19 recession is over! Although the NBER (National Bureau of Economic Research) has yet to make their official announcement, my bet is that the recession ending point is backdated all the way to last autumn, or even earlier. That’s how economics often works… with perfect 20/20 hindsight.
As the economy’s emergence from pandemic restrictions exceeds widespread forecasts and expectations, so do underlying pressures in other areas vital to the stock market’s outlook. And with the combination of a potential valuation bubble on Wall Street and corresponding housing bubble on Main Street, investor sensitivity to interest rates has never been higher.
In April 2021, the Consumer Price Index for All Urban Consumers (CPI-U) rose 0.8%, the largest one-month increase since August 2012. Over the previous 12 months, the increase was 4.2%, the highest year-over-year inflation rate since September 2008 (4.9% over prior 12 months). By contrast, inflation in 2020 was just 1.4%. (1)
The annual increase in CPI-U — often called headline inflation — was due in part to the fact that the index dropped in March 2020, the beginning of the U.S. economic shutdown in the face of the COVID-19 pandemic. Thus, the current 12-month comparison is to an unusual low point in prices. The index dropped even further in April 2020, and this “base effect” will continue to skew annual data through June. (2)
The monthly April increase, which followed a substantial 0.6% increase in March, is more indicative of the current situation. Economists expect inflation numbers to rise for some time. The question is whether they represent a temporary anomaly or the beginning of a more worrisome inflationary trend.
In considering the prospects for inflation, it’s important to understand some of the measures that economists use.
CPI-U measures the price of a fixed market basket of goods and services. As such, it is a good measure of prices consumers pay if they buy the same items over time, but it does not reflect changes in consumer behavior and can be unduly influenced by extreme increases in specific categories.
In setting economic policy, the Federal Reserve prefers a different inflation measure called the Personal Consumption Expenditures (PCE) Price Index, which is even broader than the CPI and adjusts for changes in consumer behavior — i.e. when consumers shift to purchase a different item because the preferred item is too expensive. More specifically, the Fed looks at core PCE, which rose 0.7% in April and 3.6% for the previous 12 months, slightly lower than core CPI but much higher than the Fed’s target of 2% for healthy economic growth. (3)
A Hot Economy
Based on the core numbers, inflation is not yet running high, but there are clear inflationary pressures on the U.S. economy. Loose monetary policies by the central bank and trillions of dollars in government stimulus could create excess money supply as the economy reopens. Pent-up consumer demand for goods and services is likely to rise quickly, fueled by stimulus payments and healthy savings accounts built by those who worked through the pandemic with little opportunity to spend their earnings. Businesses that shut down or cut back when the economy was closed may not be able to ramp up quickly enough to meet demand. Supply-chain disruptions and higher costs for raw materials, transportation, and labor have already led some businesses to raise prices. (4)
According to the April Wall Street Journal Economic Forecasting Survey, gross domestic product (GDP) is expected to increase at an annualized rate of 8.4% in the second quarter of 2021 and by 6.4% for the year — a torrid annual growth rate that would be the highest since 1984. As with the base effect for inflation, it’s important to keep in mind that this follows a 3.5% GDP decline in 2020. Even so, the expectation is for a hot economy through the end of the year, followed by solid 3.2% growth in 2022 before slowing down to 2.4% in 2023. (5)(6)
As investors have become increasingly concerned about inflation, the Federal Reserve has given countless reassurances that current pricing pressures will be “transitory” and short-lived. Yet mounting evidence has seemingly turned this debate into the Fed versus the World.
Will the economy get too hot to handle? Though all economists expect inflation numbers to rise in the near term, there are three different views on the potential long-term effects.
The most sanguine perspective, held by many economic policymakers including Federal Reserve Chair Jerome Powell and Treasury Secretary Janet Yellen, is that the impact will be short-lived and due primarily to the base effect with little or no long-term consequences. (7) Inflation has been abnormally low since the Great Recession, consistently lagging the Fed’s 2% target. In August 2020, the Federal Open Market Committee (FOMC) announced that it would allow inflation to run moderately above 2% for some time in order to create a 2% average over the longer term. Given this policy, the FOMC is unlikely to raise interest rates unless core PCE inflation runs well above 2% for an extended period. (8) The mid-March FOMC projection sees core PCE inflation at just 2.2% by the end of 2021, and the benchmark federal funds rate remaining at 0.0% to 0.25% through the end of 2023. (9)
The second view believes that inflation may last longer, with potentially wider consequences, but that any effects will be temporary and reversible.
The third perspective is that inflation could become a more extended problem that may be difficult to control. Both camps project that the base effects will be amplified by “demand-pull” inflation, where demand exceeds supply and pushes prices upward. The more extreme view believes this might lead to a “cost-push” effect and inflationary feedback loop where businesses, faced with less competition and higher costs, would raise prices preemptively, and workers would demand higher wages in response. (10)
Is Current Inflation “Transitory?
Dual surveys from the Institute for Supply Management (ISM) are ringing alarm bells, as the ISM Manufacturing Prices Paid Index has surged to one of its highest readings on record, led by widespread commodity price increases. As stated by one respondent to the ISM survey, “In 35 years of purchasing, I’ve never seen anything like these extended lead times and rising prices – from colors, film, corrugate to resins, they’re all up.” Likewise, even in the Service Sector the Prices Paid Index shot higher and is nearing a 25-year high.
Low inventories among companies that produce goods will undoubtedly keep price pressures high as companies scramble to replenish their depleted inventory and meet the unexpectedly high demand.” And prices have, indeed, continued to rise, while restocking efforts have been unable to prevent customer inventories from falling to a record low.
Central to the Fed’s “transitory inflation” argument is the belief that supply/demand pressures will quickly subside as inventories rebound. My concern is that broader evidence suggests inflation could be far stickier than the Fed expects.
From groceries to lumber to cars and even chickens, inflation pressures are being felt by consumers and businesses. The widespread nature of today’s inflation is one of the factors that suggest pricing pressures may be more deep-rooted than the Fed believes.
Perhaps most importantly, business owners are also facing higher wage costs as qualified labor is becoming an increasingly rare commodity. The National Federation of Independent Business (NFIB) reports that a record 44% of small businesses have unfilled positions, and over half of those with job openings reported that there were few or no qualified applicants.
Historically, wage inflation can be notoriously sticky, and the disparity between the NFIB Job Openings and reported Wage Inflation is a gap that will almost certainly be closed in the year ahead. This casts further doubt on the Fed’s narrative that inflation will surely be “transitory.” And unfortunately for the Fed, wage inflation–once ingrained–can typically only be reversed by a recession.
As businesses are facing higher input expenses, they are already making plans to pass these costs on to their customers. The National Federation of Small Business’ survey of small businesses shows that plans to raise selling prices have reached the second highest level since 1981 – a time when inflation was running near 10%.
Although it’s too early to tell whether current inflation numbers will lead to a longer-term shift, you can expect higher prices for some items as the economy reopens. Consumers don’t like higher prices, but it’s important to keep these increases in perspective. Gasoline, jet fuel, and other petroleum prices are rising after being deeply depressed during the pandemic. Airline ticket prices are increasing but remain below their pre-pandemic level. Used cars and trucks are more expensive than before the pandemic, but clothing is still cheaper. (11) Food is up 3.5% over the last 12 months, a significant increase but not extreme for prices that tend to be volatile. (12)
Anyone who has tried to buy or build a home in the past six months is aware of the rising stresses in the housing market. Home prices are soaring, not only here in the U.S. but on a global basis as well.
History has shown that it will be difficult, if not impossible, for the Federal Reserve to dampen or halt the imminent impact of the red-hot labor and housing market on the economy. Any cost surprises will undoubtedly be to the upside in the months and year ahead, and that does not bode well for inflation news OR for the Fed’s reassurance of “transitory” inflation.
For now, it may be helpful to remember that “headline inflation” does not always represent the larger economy. And with interest rates near zero, the Federal Reserve has plenty of room to make any necessary adjustments to monetary policy.
If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first. If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.
Projections are based on current conditions, are subject to change, and may not come to pass.
1, 12) U.S. Bureau of Labor Statistics, 2021
2, 4) The Wall Street Journal, April 13, 2021
3, 6) U.S. Bureau of Economic Analysis, 2021
5) The Wall Street Journal Economic Forecasting Survey, April 2021
7, 10) Bloomberg, March 29, 2021
8) The Wall Street Journal, April 14, 2021
9) Federal Reserve, 2021
11) The New York Times, April 13, 2021