Economic Outlook

The Inflation Battle Could Have Collateral Damage

• Inflation disappoints, holds at 8.2% in September

• Core inflation hits new high at 6.6%
• Federal Reserve continues to signal higher rates; determination to quell inflation
• Probability of recession increasing

Although US employment remains strong, the rapid increase in Fed-imposed interest rates coupled with historically high inflation and supply chain issues combined to restrict growth in the US to levels consistent with recession. The Fed is attempting to tamp down demand by increasing the cost of borrowing and tightening liquidity.  However, demand is already at levels that have produced two quarters of negative real growth in 2022. The Fed has taken the position that further economic contraction may be required before economic forces combine to drive inflation back to the 2% level that it seeks. Some analysts believe the recession is already here. Others argue that unemployment is too low to consider this to be a recession even though employment is a lagging indicator. Two facts are indisputable: real growth is much too low for a healthy economy, and inflation is much too high. 
 

A large part of the challenge faced by monetary policymakers lies in the fact that the dominant characteristic of the current situation—high inflation—has not been primarily caused by excess demand. Instead, current high inflation is, in large part, the product of a series of supply shocks. The Russian invasion of Ukraine cut supplies of wheat, fertilizer, soybeans, and gas. The West’s response to that invasion cut off energy exports from Russia, leading to shortages that pushed gas and oil prices to new highs. Frequent COVID lockdowns in Chinese port cities constrained the flow of parts and finished goods from the world’s leading manufacturer. Our own experience with COVID and its lockdowns disrupted key elements of our domestic supply chains and negatively impacted participation in our domestic labor markets. The result of downward pressures on supplies was higher prices, and hence, inflation.
 

Another contributor to the current inflation was the extraordinary policy response to the COVID pandemic. We certainly cannot begrudge assistance to those that needed it in the face of such an unusual threat. But the serial assistance and loan programs, coupled with an aggressively expansionary monetary policy at the Fed, had the effect of introducing trillions of new dollars into the economy at a time when real productivity was at a low. Total stimulus, including both fiscal and monetary actions, totaled as much as $5–7 trillion. From a monetary perspective, some part of the present high inflation can be attributed to the extraordinary expansion of the money supply at a time when productive growth could not absorb it. A classic cause of inflation is when the money supply expands faster than productive economic growth.
 

To address the current situation, the Fed has two primary tools: interest rates and “quantitative tightening.” Quantitative tightening is the reverse of “quantitative easing” and is the process of reducing the vast portfolio of bonds the Fed holds on its balance sheet in an effort to mop up excess cash in the financial system. Quantitative easing involves creating new money to purchase bonds in the open market. It has the effect of flooding the financial system with new money. The Fed used quantitative easing to stimulate the economy in the aftermath of the Financial Crisis and during COVID. 
 

Quantitative tightening is the opposite process of reducing the portfolio of bonds held by the Fed and draining excess money from the economy. The Fed is presently using both rate increases and quantitative tightening aggressively. Currently, the Fed is allowing $60 billion in treasuries and $35 billion in agency bonds which it holds on its books to mature without replacement every month. It is thereby reducing its holdings in bonds by those amounts each month. The process effectively removes an equal amount of cash each month from the US money supply. 
 

Quantitative tightening will be effective in removing some excess cash from the financial system, thereby removing one monetary driver of inflation. Higher interest rates can tamp down demand by making purchases and investments more expensive. However, neither of these actions directly address the supply constraints responsible for so much of the current inflationary cycle. The Fed is using the tools that it has, even though those tools may be poorly adapted to fix the type of inflation from which we suffer. Because those tools may only indirectly address one of the root causes of the present inflation—supply constraints—they risk doing greater damage to overall economic growth than might otherwise be necessary. This is not entirely intentional; they are simply using the tools that they have. The Fed may be further motivated by the nature of the data it is focused on. It is attaching considerable importance to lagging indicators, such as the Consumer Price Index (CPI) and the unemployment rate. It rarely mentions leading indicators, such as durable goods orders or new building permits, which already suggest growth is decelerating. 
 

Policymakers often overshoot in both directions, with stimulus when they perceive threats to the economy and with aggressively higher rates and a tighter money supply when inflation rears its ugly head. Very often their focus is on more concrete but lagging indicators, and it is not unusual for them to “double down” before the economy can fully react to their corrective measures. Investors and business leaders should anticipate that the probabilities of recession have increased in recent weeks, in part because the corrective measures have been so aggressive.

Overall employment increased by 263,000 in September. The rate of increase has slowed in recent months, suggesting that labor demand, which has been so strong, is declining. The number of jobs added monthly has averaged 420,000 in 2022 and 562,000 during 2021. Unemployment remained low at 3.5%. Hourly wages increased 0.3% (MOM), a deceleration from the 5% annual rate of increase seen so far this year. Taken together, these figures offer some hope that slowing labor demand might also dampen wage inflation. The labor market remains tight, and September only provides us with a single data point, but if the trends of more moderate payroll gains, increased participation, and lower wage increases persist, employment’s contribution to overall inflation may start to decline.

Inflation continues at a concerning rate and remains the central focus of policymakers. “All items” CPI (the Consumer Price Index) declined to 8.2% in September from a high of 9.1% in June and 8.5% in July. However, “core” CPI (less food and energy) actually went up to 6.6% from 5.9% in July. Declines in energy expense have helped the “all items” index; energy was down 2.1% in September after falling 5.0% in August. Gasoline declined 4.9% after falling 10.6% in August.  Help from energy may be short-lived; the most recent moves in this area have been up, and OPEC is planning to cut production in order to protect higher oil prices.
 

The fact that core prices continue to rise while the “all items” index is coming down slightly suggests that inflation has broadened out into more corners of the economy and may prove more difficult to contain. Service industries, which comprise the largest part of our economy, are now producing much of the overall inflation.
 

In spite of the bleak headline numbers, there is some evidence that some of the worst of the inflationary pressures may be behind us. Some commodities have come down sharply in recent months. Crude oil is down 29% from its price spike in June.  Corn is down over 13% from its high in May; gasoline is down 34% from its peak; wheat is down 25% from its high; lumber is down 62% from its high in March. Cotton is down 46% from May, and copper is down 34% from February. The Baltic Dry Index, a measure of the cost of moving goods globally, is down 62% over the past year.

With all these prices down, why is overall inflation still running hot? First, prices paid by consumers do not immediately and fully reflect changes in commodity prices on exchanges. Second, the inflation index weights price changes based on their impact to the typical household budget. So, housing prices are more significant than aluminum. Third, it is not enough for a commodity to hit a price point—the amount of time it spends at a certain price level can be a significant factor in driving inflation. Finally, energy, housing, food, and wages tend to have such an outsized impact on overall spending that until increases in these areas clearly moderate, overall measures of inflation will tend to run hot.  

The Federal Open Market Committee (FOMC) met on September 20 and 21 and once again raised their target for short-term rates by 0.75%. The upper end of that target is now 3.25%. Short-term rates were essentially at zero last February. The Committee’s press release and the Chairman’s comments after the meeting removed any doubt that the Committee would persist on its tightening path until inflation comes down in a meaningful way. The Committee has two more meetings through the end of 2022, and while it is expected that they will increase rates at both of those meetings, their own forecast regarding rates suggests that at least one of those increases will be for 0.50%.
 

The yield curve is inverted, with the 2year Treasury yielding 4.48% and the 10year Treasury at 4.00% at this writing. Historically, an inverted yield curve has been a precursor to recession.

Markets continue to respond negatively to the news of higher rates, higher inflation, and a slowing economy. The S&P 500 has declined about 25% so far this year.  Steep and sudden rate increases impact markets in multiple ways. First, higher rates produce lower valuations when calculating the present value of a stream of earnings.  Second, higher rates increase the cost of doing business for most commercial ventures and certainly increase the cost of any new investment by those firms.  Third, as higher rates increase the value of the dollar relative to other currencies, global sales become more costly for foreign buyers, and foreign earnings are converted back to dollars at disadvantageous rates. Finally, if the higher rates do precipitate a recession, stock prices should reflect the impact of such a recession on future earnings.
 

So far this year, corporate earnings have generally been positive, but these results are increasingly being reported with warnings from business leaders about the headwinds associated with inflation, supply chain problems, and consumers squeezed by inflation. Overall earnings for the S&P 500 have been resilient, however if you strip out profits from energy companies, much of the gain evaporates. The current price earnings ratio for the S&P 500 is 18.1; well below its spike above 30 at the end of last year, but also above the long-term average of 16. So, stocks are cheaper than they have been in recent times but not yet truly cheap in absolute terms. 
 

Earnings, like so many other measures, are backward-looking. If some of the effects of higher rates and slower growth are still working their way through corporate earnings, there may be more downside before they support another bull run.  However, markets also try to anticipate economic developments well in advance, and if inflation starts to respond to this more restrictive environment in the coming months, we may also get through the worst of the current market adjustments over the next couple of quarters.
 

For investors seeking to allocate new funds in a challenging environment, opportunities do exist in short-term fixed-income securities. A laddered portfolio of treasuries maturing on a 3–18-month schedule now yields in the vicinity of 4% with very little credit or duration risk. At some point, the Fed will reach the end of its current tightening process, and it will be advantageous to roll out of short-term strategies and into intermediate bonds. By that time, yields for intermediate, investment-grade corporate and municipal bonds should be quite attractive to long-term investors.
 

We realize that the current environment is very challenging. Negative markets do not persist forever, but it can seem that way when we are in the midst of a downturn, especially one that impacts both stocks and bonds. If we can be of any help to you during this time, please don’t hesitate to reach out.