Investment Insights - Inflation Mechanics & the Peaking Process
February 03, 2022
By Patrick V. Masso, CFA
“We are seeing very substantial inflation. It's very interesting. We are raising prices. People are raising prices to us and it's being accepted. We’ve got nine homebuilders in addition to our manufactured housing operation, which is the largest in the country. So, we really do a lot of housing. The costs are just up, up, up. Steel costs, you know, just every day they’re going up.”
Berkshire Hathaway Annual Meeting
Flashback & Inflation Drivers
From the onset of the pandemic, the United States Congress and Federal Reserve quickly initiated massive fiscal and monetary stimulus measures to backstop the frozen U.S. economy. The Coronavirus Aid, Relief, and Economic Security Act (CARES Act), which was signed into law March 27, 2020, provided $2.2 trillion in economic stimulus in the form of direct payments to American citizens and forgivable loans and grants to businesses and local governments. The Federal Reserve had also quickly cut the federal funds interest rate to close to 0% and was buying $80 billion of Treasury securities and $40 billion in agency mortgage-backed securities every month since June 2020.
Six months after the start of the pandemic, it seemed that the economic recovery had begun to stall and the unemployment rate remained in the high single digits, while COVID case counts continued to rise.
Conventional economic theory states that drastically increasing the money supply in an economy should lead to higher levels of inflation. However, a central tenet of the newly touted (arguably controversial) Modern Monetary Theory, “MMT”, states that governments which are able to create their own currency can “print” and spend as much of it as they wish with little impact on inflation until full employment is reached. Then, the government can start raising taxes to reduce runaway spending and the corresponding inflation that follows.
Inflation decreases the purchasing power of those monies, which leads to the need to print more, which, of course, further depreciates the value. Mr. Buffett was spot on in his assessment of the future trajectory of inflation – we are now sitting at a multidecade high in the rate of inflation.
Let’s briefly discuss the mechanics of inflation…
Calculation & Historical Perspective
First, it is important to know how inflation is measured. In the United States, the most common measure is the Consumer Price Index (CPI). This index has a base value of 100 that starts in the time period of 1982 to 1984. The CPI measures the price change of a basket of goods and services that are typical for an American consumer: housing, food, medical, and transportation expenses, to name a few categories. The weighted average of these values is then calculated. In times of inflation, the index value increases; in times of deflation, the index value decreases. To get the annual percentage change of CPI that is often quoted in the media, you simply take the value of the index, subtract the value of the same time period a year ago, and then divide the difference by the previous value. In Exhibit 1 below, you can see the current CPI measure was at 7.04% in December 2021. A value close to that has not been seen since October 1990, and, before that, the high inflation environment of the early 1980s.
Housing, Lags, & Supply Chain Issues
Housing costs are typically a large part of the CPI calculation. Rent and owner’s equivalent rent, which is a measure of how much money a property owner would have to pay in rent to be equivalent to their cost of ownership, is about a third of the current CPI basket. In the early days of the pandemic, eviction moratoriums were put in place. Because of these moratoriums and how rent is calculated within CPI, the rent inflation component was understated. This is reflected in Exhibit 2, which shows the percentage change of rent CPI has gone practically straight up since the bottom in April 2021, and now sits around 3%. Expect rent inflation to continue to increase over the coming months.
Inflation takes some time to percolate throughout an economy, especially in these unique circumstances. While the actions of the Fed and U.S. Congress stimulated the economy and put money in the hands of consumers, at the beginning of the pandemic, businesses were closed! Consumers could not spend this excess cash. When businesses were finally able to reopen, a large portion had supply chain issues from COVID-related circumstances, such as workers testing positive for the virus and being unable to work for a few weeks. Because demand for goods and services was so strong after the reopening, some businesses found themselves without necessary raw materials to meet demand. These supply and demand imbalances that have been a major contributor to the recent spike in inflation will need some more time to work themselves out as supply capacity is increased.
The other driving force that will determine how long these increased levels of inflation will stick around is wage growth. Economists believe that, as wages increase, businesses will need to raise prices in order to increase the pay of their workers while maintaining their operating and net profit margins. We can already see the increasing trend of wages displayed in the chart of the Index of Aggregate Weekly Payrolls of all Private Employees (Exhibit 3 below). You can see how it sharply dropped through the beginning of the pandemic when millions of employees were originally laid off. Now, we have quickly surpassed the pre-pandemic high. As worker shortages across the country continue to put pressure on businesses to increase wages, we will wait and see if this has a lagged effect on inflation, as it typically does.
The Fed’s Response
As you have probably heard before, one part of the Federal Reserve’s dual mandate is to stabilize the inflation level (the other being to achieve maximum employment). Typically, the Fed has targeted a 2% annual inflation rate. The Fed, prior to the pandemic, had said they would let inflation run a little above the 2% level for a time but were still having trouble getting the CPI and other inflation indicators to that level. With inflation now north of 7%, many have called for the Fed to step in and raise the Federal Funds target rate. The Fed has already undertaken the first step in this process. As of October 2021, the Fed has begun to taper, by about $15 billion a month, the previously mentioned asset purchases. In December 2021, this reduction doubled to $30 billion. At this pace, the Fed will complete its taper and stop purchasing assets by the end of Q1 2022.
The next step will be to begin open market operations, selling Treasury securities to commercial banks, to raise the Federal Funds rate, which is the overnight lending rate for highly creditworthy commercial banks in the United States.
The 12-member Federal Open Market Committee (FOMC) is responsible for setting the Federal Funds rate. At eight different scheduled meetings throughout the year, these members vote to either increase or decrease the Federal Funds rate when they deem appropriate. At these meetings, the committee is polled on their expectations for the Federal Funds rate over the next year. These expectations are communicated, and the difference between the year’s ending median expected rate and the current rate infers the number of rate increases or decreases.
Currently, the median projection of the Federal Funds rate by the end of 2022 is 0.90%, which would imply three to four rate hikes during the year (each at 0.25%). We will monitor how the market responds to the Fed’s actions and how expectations change as more economic data is reported. In the meantime, we can only ride along with the Federal Reserve as it takes steps to moderate inflation.
While we expect year-over-year inflation rates to remain above the stodgy sub-2% levels seen before the virus for the balance of 2022, our view is that it is highly probable the acceleration in the rate of inflation will transition into deceleration mode. The most recent figure for December, 7.04% year-over-year, should come very close to marking the peak in inflation for this business cycle. As the year unfolds, anticipate inflation to steadily grind lower to and through 5% or less – still tall relative to the previous business cycle, but well on the way to less pronounced levels. The ISM Prices Paid Index (Exhibit 4 below), which reflects the change in prices paid by surveyed industry representatives, shows this peaking process might already be underway…
The backdrop of tightening monetary policy during 2022, as outlined by the Fed, could be untimely. In fact, with the benefit of hindsight, you could cogently argue that a policy mistake has already been committed and there are real risks of compounding the error. Specifically, the Fed is at risk of tightening policy right into the apex of a slowing, albeit still growing, economy experiencing peak inflation. Fiscal spending is also set to transition from a tailwind to a headwind and slow from a whopping $6.85 trillion to “just” $5.55 trillion, the bulk of which should be felt in Q2 ’22 due to the stimulus checks that were distributed in March ’21.
The convergence of these various factors at this specific point in time make it more understandable that risk assets, like stocks, could be more susceptible to a mid-cycle slowdown air pocket. That is not to say positive returns are off the table for 2022, but that after three years of strong double-digit returns, it should not come as a surprise. Making thoughtful and timely tactical adjustments could increase in importance as the year progresses.
Pivoting away from more cyclical, inflation- sensitive areas, such as commodities, and toward more interest rate-sensitive or less cyclical sectors like consumer staples or health care could be presenting an opportunity. Unlike 2021, the forward-looking mix of factors could be a net positive for bond returns, which struggled to just break even in 2021. Moving up the quality spectrum, regardless of asset class, could also make incremental investing sense. We plan to maintain an increasingly nimble stance in portfolios and look out the windshield more than the rearview mirror for our investors!
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