In September 2020 Jay Powell announced that the Federal Reserve would adjust how it reacts to inflation, one of its chief mandates, and allow inflation to run hotter for longer. The expectation is that it will be several years before the Fed raises interest rates. Traditionally, elevated rates of inflation indicate the economy is operating at full capacity and may be in danger overheating. Following the COVID recession of 2020 the Fed is trying to create a positive environment for the recovery.
In the Spring of 2021 signs of inflation are abundant. Since the fall of 2020 commodity prices had risen dramatically. Lumber prices had soared as supply constraints limited what was available, especially as housing prices went up and building accelerated. Copper surged to new record highs. Wheat, corn and other food commodities went up as the economy reopened and supply couldn’t keep up with demand.
Among tech businesses a shortage of computer chips affected the building of everything from cars to exercise equipment. “Just in time” supply chains showed increasing strain.
To top things off, a gasoline pipeline was held hostage by a ransomware attack in early May 2021. The result was gasoline shortages and higher prices throughout the east coast US.
While vaccinations were having a positive effect on opening the economy and the economy was recovering from the lockdowns in 2020, there is a question of how much structural damage was done by the recession. According to Bloomberg several million businesses were force to permanently close due to the lockdowns and most will likely not reopen… Though most people have returned to work and many businesses struggle to find employees, there are 8 million fewer jobs then before COVID.
Several investors and economists have insights as to where we are and what it means for investments.
Recently Sam Zell, billionaire investor was asked “whether inflation will be transitory, as Federal Reserve Chairman Jerome Powell indicated last week.
“Oh boy, we’re seeing it all over the place,” Zell said of inflation. “You read about lumber prices, but we’re seeing it in all of our businesses. The obvious bottlenecks in the supply chain arena are pushing up prices. It’s very reminiscent of the ‘70s.” (1)
On March 30th, 2021 Joquim Fels, Pimco managing director was interviewed on Bloomberg by Alix Steel.
In Pimco’s 2nd quarter newsletter, Fels advised investors should be aware of an inflation head fake and maintain portfolio flexibility. (2)
Fels said, “I think what we are seeing is a head fake, particularly when it comes to inflation, so inflation is going to move higher in the next few months and markets have priced that in, but we think it’s going to be a spike and not a spiral. A lot of the factors that will push inflation higher are one-offs, partly its due to energy prices increasing which we think will not continue, and… as the economy reopens you will see price adjustments, but again we think this will be temporary. Later this year inflation will come back down again, we will spend the second half of this year and most of next year below the Fed’s target. In that sense, we think what is happening now is a head fake.”
Fels continued to say Pimco thinks investors should prepare for some more volatility because investors may be spoked by the run up in inflation.
Alix steel asks “if we are going to get a $3tril infrastructure package, why isn’t that going to be inflationary?”
Fels responds, “well, I think for two reasons. The first one is if you get an infrastructure spending package the spending will not come on stream immediately. This is a multiyear thing. There aren’t that many shovel ready projects, so this is not something that will hit the economy all at once. Secondly, I think a significant part of this infrastructure spending is going to be financed with tax increases. So the net stimulus will be much smaller than the headline number.”
Congress continues to debate the size and composition of the infrastructure bill, with the amount being reduced in size and scope.
On Bloomberg Surveillance on 4/1/2021 Carl Riccadonna of Bloomberg Economics shared some insights on the benefits of letting the economy running hot. “In a healthy way we are turning this back to a sustainable pace of growth, certainly a little bit more inflation in the economy than we saw in the last cycle would be a healthy development for interest rates which factors into financial stability which factors into the sustainability of the economic cycle. If we have a low growth, low inflation environment with rock bottom interest rates, that’s actually not that healthy because that causes froth in financial markets as we saw in the last economic cycle. This time letting things diversify a bit, letting the economy run hot for a longer period of time, bake some inflation expectation in to the system, pushing some credit spreads wider that’s a very healthy development for a mid to late cycle economy. Letting that develop will have some profound consequences for the system, especially structurally.” (3)
Romaine Bostick asks about productivity in the economy. Productivity increases have been low for several decades. Riccadonna responds, “We have been in a slowing productivity and low productivity environment for the better part of 40 years. It takes tremendous capital investment to turn that around. 99 out of 100 economists will tell you you can’t forecast productivity growth, and you happen to be talking to the one economist that says yes we can. The way we model it is through labor costs. If labor costs are low as they have been in cycle after cycle, there’s not a lot of incentive to improve productivity. If we let the economy run hot and let wage pressures increase, then businesses are incentivized to work around rising labor costs and invest in productivity enhancing capital spending. There’s been little need to do that because wage pressures have been so stagnant over the last couple of economic cycles.”
In the first half of 2021 many companies raised their minimum wage to $15/hr. To lure in new hires many companies are offering bonuses.
Later Tom Keene of Bloomberg talks to Ellen Zentner, Morgan Stanley chief US economist about the Fed’s stance on inflation and the market cycle… (3)
Zentner says “This could be a shorter but hotter cycle. Recognize that extreme element of fiscal support and monetary policy… I wouldn’t think of this in the 10 year view but a 5 year cycle… Part of this is the Fed’s decision to keep rates low for years, but eventually the Fed will have to step in and raise rates.”
In a conversation between Jon Ferro of Bloomberg and Priya Misra, TD securities global head of rates strategy… (3)
Misra states “its going to be a long haul to really recover that quickly and get inflation higher. Where I’m also a little bit nervous is around bond market outflows… do we start to see bond market outflows because of the rate move, not because people are concerned about credit, but there is real and high duration risk in some of these IG (investment grade) markets.”
The challenge, and fear among many is ‘what if inflation takes off quickly to higher levels’. This fear became reality on May 12th, 2021 when the CPI and inflation numbers were released and showed the highest inflation rate since 2009. Micheal McKee of Bloomberg described the numbers as “hotter than anticipated, increasing .8%, markets were expecting a .2% gain. That pushes the YoY inflation rate to 4.2%. That’s much faster than the 2.6% we saw in March.” (4)
Markets reacted… The US 10 year yield rose 1.68% on expectations the Fed will have to react sooner than planned by raising rates. US equity markets sold off.
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