The Dow suffered its worst week since October after the Federal Reserve suggested that it might move forward with its intentions to reduce bond purchases and raise the Federal Funds rate.
Note the word intentions above. Nothing has been implemented yet. What the Fed said last week, through formal statements and comments from Fed officials, is that it sees that the economy is recovering from the pandemic at a quicker pace than it expected, and that the stronger pace is leading to faster than anticipated price increases. While still labeling the price changes as transient, the Fed was aware that recent strength could result in higher than expected long term inflation. While it is too soon to tell, the possibility/probability exists that it may be required to take steps to react sooner than it previously anticipated.
Nothing is happening today. Even the most hawkish of the Fed officials said it would take at least a few more Fed meetings to digest the news and become convinced as to how much of the current inflation wave will fade as supply and demand rebalance, and how much becomes systemic. What is most important for the long term and for interest rates, is how much gets rooted in 5-10 year inflation expectations. That is what ultimately gets rooted in bond prices.
Clearly, a significant amount of near term inflation relates to producers of commodity goods underestimating the speed of the recovery in recent months. We have all witnessed the impact of spikes in prices from lumber to gasoline. We have all seen the shortages and out of stock situations ranging from washing machines to ketchup packets. Not only did demand surge faster than expected, but manufacturers drained inventories during the pandemic to conserve cash leaving no safety cushion. In some cases, the shortages are already starting to abate. Lumber prices are already down about a third from their peak just a month ago. Other shortages may take a year or longer to be rectified. But most of these mismatches will be resolved, and when that happens, prices will stabilize as well.
But labor costs are just starting to rise. Employment costs are viewed by economists as a lagging indicator. Today, there are about 7 million people still unemployed and over 9 million new job postings. The labor market is clearly tight even with millions more out of work than pre-pandemic. Part of the reason is a mismatch of skills. Part relates to enhanced unemployment benefits incentivizing some to stay home. A big part relates to 2-3 million who retired during the pandemic. History will tell us why. Today, we know that filling jobs is hard. Companies across the board are raising wages. As our economy has morphed from a manufacturing base to a service base, labor costs take on greater importance. That is why, although wages to date have not been a major inflationary factor, they will be in the months and years ahead.
Thus, the Fed sees all of this and will likely consider in the months ahead an adjustment to its pace of bond purchases and ultimately the future path of the Fed Funds rate. The financial markets hate surprises. They were clearly jolted last week by the relatively sudden change in attitude of the Fed. While nothing actually happened in terms of what the Fed is doing today, future intentions matter a lot.
As the recovery matures, the Fed may change what it does again. For one, Congress is considering up to $4 trillion in additional spending over the next decade with the majority concentrated in the early years. Nothing has been approved yet. But clearly, there is a wide range of possible economic outcomes between no change and an additional $400-500 billion Federal spending per year. Rightfully, the Fed doesn’t speculate as to what Congress might do. It reacts to what happens.
At the start of this year, the Fed estimated that real growth in 2021 would approximate 4%. Now it expects 7%. Inflation is now predicted to be about 3.4%, a full percentage point higher than previous forecasts. That can’t be ignored. Annualized growth at the moment is closer to 10%. But growth at this rate is unsustainable. Our population is growing less than 1% per year. Productivity can add a bit but anything over 4-5% is way over historic trends. Next year growth should be 3-4% according to economists today. That means closer to 4% at the start of the year, and less than 3% when 2022 ends. That isn’t far from trendline growth rates.
It all makes sense. Once we were all released from our Covid-19 cocoons, the urge to get out and catch up was overwhelming. We quickly went on vacation, the first for many since 2019. We visited family in person rather than Zoom. We had parties, went to sporting venues, and even bought a new car. Everyone wanted to do the same thing. But the surge clearly won’t last. By the fall, students will be back in the classroom. Office workers will return to their desks. Yes, there will still be some working from home full-time or part-time. But we work collaboratively and that is more difficult when everyone is miles apart, Zoom or no Zoom.
The temporary inflation we see today will elevate future prices. But the way we measure long term inflation is by calculating the changes from period to period. Many restaurants, for instance, have raised menu prices as they reopen. But will they raise them again next year? They could but if they raise them too much, they drive customers away. Wages may keep rising, but other costs, like fuel, food commodities and paper goods will probably recede after supply and demand return to balance.
Indeed, that questions whether and how much the Fed will pull back in 2022 and beyond if growth quickly moves back down toward trendline. If growth in late 2022, for instance, is back below 3% annualized, how quick will the Fed want to withdraw stimulus from the market?
It is important to keep that thought in context. The Fed wants full employment. It is likely that will be achieved by the end of 2022, if not sooner. The Fed wants stable prices. Clearly, its recognition expressed last week, that inflationary pressures bear watching suggest that it is on the case. The Fed also wants maximum sustainable growth. That is a bit problematic starting later next year when “normal” quarters once again get compared to “normal” quarters. That is why policy remains fluid.
Forget Fed predictions. Its track record is awful. Don’t take that as criticism. It simply suggests that predicting economic growth or inflation two years out is nearly impossible. Rather than taking predictions literally, the changes in the dot plots are looked at as a sign of where concerns lie. Last week, the Fed said it was more concerned than it had been about inflation and is prepared, as necessary, to take action to keep it in line with targets. Essentially, that was its entire message.
Markets didn’t overreact. The bond yield curve (the spread between long and short term rates) flattened a bit, signaling that markets see the current economic surge as temporary. Long term yields didn’t budge although they moved around quite a bit. Stocks that benefited by higher inflation and higher rates sold off. Tech stocks that command high P/E ratios (consistent with continued low future interest rates) did well. Thus, the stock market’s message was that inflation should remain tame and long term interest rates should remain low. I would modify that a bit. Long term inflation should remain contained. Whether interest rates stay negative in real terms will depend on whether and how fast the Fed tapers bond purchases. Just as the Fed chooses to be data driven, the path of long term rates will be highly influenced by how fast and for how long the Fed tapers its bond buying pace. The US government will need to raise $2-3 trillion per year to finance deficits, particularly if Democrats can force through a lot of new spending programs. The Fed may be forced to monetize part of that debt to keep rates low enough to allow the economy to sustain average or above-average growth. Without Fed intervention 2% inflation would be consistent with a 3% 10-year bond yield or even higher. That is why while the Fed talks of returning to a point where it can keep its balance sheet flat, the need to keep rates at or below certain levels may require some long term continuation of its bond buying program beyond the replacement of maturing debt. But that is a story for another day.
For now, the end of Q2 is near. Earnings will be sensational. The focus will turn to what happens next. That will be the tale of the second quarter earnings commentaries beginning in about 3 weeks. Stay tuned.
Today, Prince William is 39.
James M. Meyer, CFA 610-260-2220