Few topics today garner as much discussion within the capital markets as the outlook for U.S. inflation. And why not? The Federal Reserve continues to be highly accommodative with short-term interest rates near 0% and confirmation coming out of this week’s meeting that the Fed doesn’t expect to increase rates through 2023.
Also, the U.S. money supply is expanding rapidly, ongoing quantitative easing continues and the third round of fiscal stimulus is currently being distributed, adding more to the nearly $3 trillion in stimulus doled out last year. All of this combined means the nation’s total outstanding debt has surpassed $27 trillion and climbing. In addition, economic growth seems to be recovering from the effects of the COVID-19 pandemic as additional vaccines are approved and Americans move towards the Great Reopening.
Surely this environment means the Fed should raise interest rates to slow the economy, protect the value of the U.S. dollar
and reduce the risk of much higher inflation.
Maybe not. Some areas of the economy are seeing inflationary trends while others are in a disinflationary (or even deflationary) trend. For example, inflation is a problem for residential home builders with lumber prices at record highs. Yet if you own commercial office towers, rents are going lower, meaning this sector is deflating.
This week’s commentary by Fed officials including Chair Jerome Powell indicate an outlook with improved economic forecasts, but where interest rates stay low for an extended period. As we think about inflation, three primary sources of price changes within the economy come into view:
1. The cost of labor still has a way to go: As Congress continues to move additional fiscal stimulus forward, longer-term interest rates in the Treasury securities market have increased. This raises the question of whether or not the bond market is beginning to forecast growth and inflation, at levels that will require the Fed to increase rates faster than currently predicted. Is there a real risk of inflation becoming an even more serious problem as the markets question the value of the dollar?
At present, The Fed sees little risk of troublesome levels of inflation. It acknowledges that inflation may appear to be accelerating as the U.S. recovers from the worst effects of the pandemic. Inflation data for March, April and May in particular could show increases compared to the year-ago period when the economy was contracting.
However, the Fed is quick to point out that this “reflation” is not actual inflation. From the Fed’s viewpoint, the labor market weakness — still some 10 million jobs short of pre-pandemic levels — means that labor costs will remain muted for some time. The Fed would also point out that before the pandemic, unemployment was at generational lows, around 3.5%, and sustainable inflation did not rise above 2% at that time. Until the labor market heals materially from here, the most important driver of inflation is missing.
2. Rent inflation is mixed at best: U.S. home values have been going up as a result of record low levels of mortgage rates. This strength has been a welcome source of economic growth. But changes in the mix between cities and suburbs and the shifting outlook for commercial space including offices and retail mean areas of price increases are being offset by price declines. Also, millions of people are having difficulty meeting rent payments. The result is the outlook for inflation in rents is uncertain.
3. Inflation in commodities seems temporary: Inflation is more apparent in the commodities market, including precious metals, industrial metals, agricultural commodities and energy The Fed historically has removed many commodities from the equation by looking at inflation on an ex-food and energy basis. There is merit to this approach as commodity prices are historically volatile. This means the inflation numbers including food and energy have been much more variable than those without them.
Using the so-called “core” rate of inflation helps avoid Fed decisions that might have to be quickly reversed. This also leads the Fed to use a term to describe highly erratic price movements as “transitory.” Therefore, these changes are not deemed sustainable and do not require a change in U.S. monetary policy. The Fed currently sees most price increases in commodities to be “transitory” and the areas of concern for more “sustainable” increases, labor and rent, to remain at levels that do not signal troublesome inflation in the near future.
The response to the pandemic, both from the Federal Reserve and Congress, has successfully mitigated the worst of its impact, but now the U.S. is in a fiscal position that may very well limit its choices in the future. The ultimate effects on the economy, inflation and the dollar are unknown, but for the foreseeable future, expect the Fed to remain accommodative and welcome economic growth.
Sustainable inflation will occur only if a lot of excellent outcomes materialize: reopening the economy fully, employment gains that spread to more parts of the workforce and economic growth at levels above recent history for an extended period. In many ways all that sounds wonderful.
Steve Wyett is chief investment strategist at BOK Financial.