Stocks rose again on Friday after the Federal Reserve formalized its policy to back away from inflation targeting. Instead it is moving toward trying to keep inflation within a range that averages about 2%. Since inflation has been below 2% for some time, its previous target, the new averaging policy will allow the Fed to let inflation run higher than 2% before requiring any tightening of policy. That means interest rates are going to stay low for even longer than under previous policy. Good for stocks. We’ll see over time whether it is good policy.
There is a lot to support the notion of low rates for a longer period of time. Capacity utilization hovers around 70%, a good 10 percentage points below what one would normally consider a level that would give manufacturers pricing power. Unemployment sits around 10%. We saw little inflation when it was below 4%. The savings rate is over 17%, more than double what it was pre-Covid-19.
While spending is rising once again as our economy continues to reopen, it remains well below levels of several months ago. The question is whether spending is constrained by nervousness and unemployment, or whether it is constrained simply because many sectors of the economy remain closed or are barely open.
While both may have some impact, I believe the major cause of constrained spending is the lack of opportunity or virus-related fear. Airline passengers are still 70% below early winter levels. Indoor dining is down over 50%. No one is buying a suit. There are no weddings or big celebrations. Vacations are limited to where we can drive. No cruises. No fancy trips to Europe. No wonder savings are building.
At some point, Covid-19 fear will dissipate. Maybe it will be the emergence of vaccines. Maybe it will simply be herd immunity. It will pass. And when it does, the big question is whether the end of cabin fever will unleash a spending spree or whether newly acquired habits will leave us all a bit cautious. We can all make our own predictions, but no one knows. This will be unchartered waters.
If the recovery is gradual, the Fed may have it right. Inflation could return very gradually, and rates will stay low for a very long time. Great for stocks and virtually all real assets.
But there is another possibility. Housing is already entering the strongest market in 15 years. Millennials are already out there buying that suburban home with 4 bedrooms and a back yard. They were doing that before Covid-19. But as with so many trends, the pandemic was an accelerant. Resales are up almost double in just two months. Housing starts are the highest since the Great Recession. And it may only be beginning. If they are moving from city to suburb, then they need a car. Maybe two. Auto sales are strong.
Inflation comes in two fashions. The traditional measure of inflation is based on the price of goods and services we consume. It is measured by the Consumer Price Index (CPI) or the Personal Consumption Expenditures (PCE). Both have been persistently below 2% as noted earlier. The other measure is asset price inflation. That doesn’t impact us as we spend but it impacts our net worth. The two biggest factors here are stock prices and home prices. Both are now rising sharply. Why? Since we can’t spend on consumption for reasons just noted, we invest, raising asset prices.
But what happens if, instead of adding to investments, we spend more when Covid-19 fears dissipate? Do asset prices rise more slowly? Does consumption rise, increasing upward pressure on inflation? That is the $64,000 question. If it does, then the idea of inflation averaging, where the Fed lets interest rates run a bit hot, runs the risk of inflation going up faster than expected and the Fed failing to react in time.
But those are risks we can’t evaluate today. Over the near term, low for longer means short- term interest rates will be negative, adjusted for inflation. That will push savings into assets that can offset inflation. That includes stocks, bonds, real estate, gold, art and almost anything tangible. Of course, that includes homes, which fall into the real estate bucket.
In order to win in this environment, one must have been able to invest, either in financial assets or a home. Those that can’t get left behind. Hence, income and net worth disparity widens. That is a subject for a non-economic newsletter, but it is a serious subject.
Thus, stocks and other tangible asset classes are likely to move higher. There will be rotation between sectors, to be sure. But the laws of supply and demand dictate that more demand, as the Fed increases purchases, will increase asset prices unless the money the Fed sends into markets finds its way into consumption rather than savings. If and when that happens, the inflationary pressure on prices will shift from higher asset prices to higher consumer prices. If and when that occurs, the Fed will have to react. If it reacts too late, it could get caught in the classic case of inflation, causing the Fed to step on the brakes, creating a recession. But that is an if for the future, not now.
Today, Chris Tucker is 49. Richard Gere is 71.
James M. Meyer, CFA 610-260-2220