Stocks were mixed yesterday, although the NASDAQ Composite managed a 1%+ gain ahead of the conclusion of the FOMC’s two-day meeting. The Fed is likely to give more details relative to its intent to keep short-term rates anchored near zero for an extended period of time.
The low interest rate setting is not without risks. First, it promotes bad investments as well as good ones. What that means is that excess capacity will exist for a longer period of time. From an inflation standpoint, that’s good. Anytime supply exceeds demand, the pressure on price is downward. Inefficient investments rob revenue from the efficient. Eventually bad investments fail, but not before extracting some damage. Second, the temptation to borrow at negative real rates means that debt totals escalate dramatically both in the government and private sectors. As long as rates remain low, the capacity to service the debt remains intact. Should rates rise in the future, for whatever reason, debt service costs will cut into profits like a hot knife through butter. At the Federal level, higher debt service costs cannot be legislated away. Funds to service debt will have to come from somewhere else, today that somewhere else is more borrowing and more debt. Rational analysis would conclude that path has an ending point.
All of those problems are problems of the future. The Fed has stepped in to bail out the economy in dramatic fashion twice within a dozen years. While the extent of monetary easing has varied over that time, only in 2018 has the Fed had the audacity to tighten policy even a smidge. The result was the only down year for stocks since 2008. The Fed would like to keep rates ultralow indefinitely, for all of the reasons noted already.
In order to accomplish this, inflation must remain low. Zero rates and rising inflation has its limit. What the Fed has going in its favor is technology and excess capacity. Right now, there is plenty of excess capacity. That includes both money and labor. There are some periodic shortages associated with the pandemic and related broken supply chains, but overall inflation is contained.
If you look back over the past decade, when inflation has averaged less than 2% and you look deeper into the numbers, you will see that there are two worlds. A world of products and a world of services. Services have a high labor component. Up until the pandemic hit, labor was the one cost component in relatively short supply. As a result of this, product inflation was lower than service inflation. Technology also comes into play here. Technology is highly deflationary. In almost every instance, technological advances lower the cost of doing business, whether it be robots replacing humans or cloud computing replacing on-premise servers. The Internet, which allows enhanced price discovery, is particularly deflationary.
During the pandemic, with millions now furloughed or laid off, labor shortages have seemingly vanished. Labor is no longer in short supply with the exception of highly skilled positions. In addition, the pandemic has changed the composition of GDP. So many services from restaurants to luxury vacations are on hold until the pandemic disappears. Instead, we stay home and consume products. These products could be packaged food or a downloaded movie. In inflation terms, we are unwittingly substituting products with low labor component costs for services with high labor costs. That serves to dampen inflation.
Most inflation indices measure the costs of living, the expenses we incur leading our daily lives. Inflation doesn’t reflect changes in asset values. If your favorite stock doubles you smile; you don’t sing the woes of inflation. What about housing? Home prices are starting to increase sharply, not in urban centers perhaps, but almost everywhere else. Most of us borrow money via mortgages when we buy homes. The price of the house is much less important than the monthly mortgage payment. From a cost of living standpoint, it is the cost to service the mortgage or rental expenses that are key.
What we have been seeing for years is the dichotomy of rising asset values alongside barely visible inflation. We are saving more and spending less. That is punctuated by the impact of the virus which prevents us from spending, and therefore results in higher savings. That won’t continue indefinitely. When the virus runs its course, will there be a spending frenzy to catch up for the time we were cooped up? That could happen, but think for a minute. You may take a special vacation, but are you going to go to more concerts or football games? My guess is that you will simply return to old routines. And you might not do that so fast. Having meals delivered may have become appealing. Are you going to buy a new suit? For myself, I can’t imagine ever buying a suit again! I certainly don’t need more workout clothes. I have been living in them for months. It isn’t the goods that I am missing, it’s catching up on the experiences.
It is those experiences that may push the inflation needle higher. Charities need to become reacquainted with their donor base. Colleges will bring back the students. We will fly for vacations or to visit friends and relatives. Prices may not rise right away; no one wants to chase away old friends before they are reacquainted. As the GDP mix shifts back toward services it will nudge the inflation needle upward.
There are residual effects of asset inflation. Those rising home prices ultimately will lift rents for those who cannot afford their own homes. Oversupplied services, like ride sharing, will lift rates as volumes increase. Airlines will be forced to lift prices to cover the additional debt costs incurred during the pandemic. Restaurants will be in short supply. The pandemic is killing many, forcing a lot of closures. No one is opening a new restaurant today. Technology will remain a deflationary factor. Kiosks and electronic menus will replace order takers. Hotel check-in’s will be done with a phone. As excess capacity is either absorbed or abandoned, inflationary pressures threaten to rise. That is probably a 2022 or later event but it bears watching.
In the meantime, the Fed provides the perfect backdrop for stocks, zero rates, ultra-high P/E ratios, and an improving economy from a pandemic-created recession. The ultimate question is how long does this world last? Until there are hints that an end is near, the path is higher recognizing the short-term volatility related to the election.
Today, Amy Poehler is 49. David Copperfield turns 64.
James M. Meyer, CFA 610-260-2220