Inflation is rampant in the US
Inflation is a key market force and impacts everything from earnings to prices & real wages. The headline Consumer Price Index (CPI), an index that is used by policymakers to measure inflation, stood at 7.5% in January, which is the highest in four decades, as show in the below chart from Tradingeconomics.
Experts have stated that a rise in food staples, along with used vehicle prices have been key drivers of CPI. The initial inflation numbers in 2021 were considered transitionary by policymakers, as they estimated the impact of the base effect of changing prices.
Demand for consumption rapidly fell in 2020, with the inception of pandemic induced lockdowns. Subsequently, the Federal Reserve introduced an accommodative monetary policy, with low-interest rates & an influx of cash through bond purchases.
The government also aided consumers through stimulus checks, which left households flush with cash. All in all, households in the US had $1 trillion in savings and gains a year later, which would inevitably lead to higher prices down the line.
With a strong rebound in demand in 2021, inflation surged, but the fed maintained its stance that inflation would pass soon. However, policymakers must not have expected what came next, with CPI continuing to exceed the level of each previous month, and is now a real headache for the Federal Reserve.
Key Drivers of Inflation
Supply Chain Constraints & the Rapid Rise in Wages are two factors that Policy Makers might have brushed over in 2020. However, everything from graphics cards & consumer electronics to used & new automobiles are in short supply following a shutdown & subsequent restart in production.
Key components used across industries such as semiconductors and raw materials such as iron/steel remain back-ordered, resulting in a halt in production. Production constraints across Asia early in the pandemic, in addition to challenges through the supply chain, have resulted in price spikes, product shortages & year long-delays.
Labor related inflation has also unexpectedly been a large contributor over the last few quarters. At the start of the pandemic, unemployment was at a multi-decade high, as tens of millions lost their jobs, resulting in a halt in production & economic activity.
In addition, employees across low-value industries decided to quit, in a phenomenon that came to be known as the great resignation, in pursuit of a new start.
As a result, the Federal Reserve & the Government introduced a large number of measures to support workers, including stimulus checks, unemployment insurance and bonuses to companies to hire workers.
As a consequence of these initiatives, the labor market quickly rebounded, with unemployment levels dropping from 14% in April 2020 to just 4% recently. On average, payroll has increased between 125,000 and 200,000 jobs each month, with January seeing over 467,000 jobs.
While job growth may be strong, the incentives & policies may have resulted in a labor shortage. Currently, there are over 10 million vacant jobs that need to be filled, and companies are in a race to fill positions through incentives & higher wages.
Both McDonald’s & Amazon have raised their minimum wage to $15 and $18 respectively, with prices subsequently transferring over to consumers in the long run. See what McDonald's say about that in this nice article from CNBC,
The Current Economy Parallels the 1970s
Policymakers at the Federal Reserve have had a long-term inflation target of 2%, which they believe is key to producing stable growth. With inflation averaging between 5-7%, the current economy parallels that of the 1970s.
Back in the 1970s, inflation averaged 7% due to a 12% increase in the money supply, along with a combination of a spike in oil prices & wage pressures. Things seem dire now, with a 35% increase in money supply over the last two years.
Furthermore, the Fed’s monthly $120 billion purchase of US treasuries and Mortgaged Backed securities at a time when equity valuations had reached peak levels, could mean more pain for the markets when it subsequently reverses course.
Market participants fear that the Fed may already be late to combat inflation, and the resulting economic conditions could parallel that of the 1970s.
A combination of hyperinflation and stagnant earnings brought about the term stagflation, which resulted in both real returns and wages eroding. A similar instance of stagnation in 2022 could prove detrimental not only to equities and bonds but also in the housing & cryptocurrency markets.
Understanding the Predicament of the Fed
With inflation running rampant, Fed Chair Jerome Powell has recently taken a very hawkish stance, indicating several rate hikes in the year. Unlike in 2015 when Fed officials voted for a gradual approach, Powell has left the door open for a chance of an interest rate hike in each of the Fed’s remaining seven meetings in the year.
Powell has also refused to rule out a 50 bps increase rather than a 25 bps increase that investors had anticipated.
A rise in interest rates slows down credit circulation in the economy, which in turn should ease inflation. On the other hand, rising rates result in result in a higher risk of default for both home and auto loans, including a recession and ramping up unemployment.
For context, it took nine years for the US to reach the same unemployment rate after the 2008 crash, signaling the delicate nature of the economy.
The US National Debt has now topped $30 trillion amidst increased spending from the government to combat the effects of the pandemic. A 1% rate hike could result in additional $300 billion interest payments, further increasing the budget deficit and weakening the economy in the long run.
Powell now faces a lose-lose scenario. Take a hawkish stance & raise rates aggressively, to set the economy with a recession or keep rates at record lows and see stagflation take over.
Either scenario could spell doom for the economy, but Powell has vowed to stay ‘nimble’.
Only time will tell if his approach gets the US economy out of the current predicament.
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