Inflation: Maybe Not Dead Yet

In the 1974 cult classic, Monty Python and the Holy Grail, viewers are invited to engage in a bit of black humor as the film traces the characters through the plague ridden Middle Ages. As one of the characters proclaims “…I’m not dead yet!…” one of the village residents “helpfully” strikes the unfortunate character to “help him on his way” and get village life back to normal. In some ways, the macabre incident could describe the attitude toward inflation with the victims being workers and investors.

Perhaps the most anticipated question of 2023 is “…will there be a recession?” The answer: in all likelihood, yes. In order to restore price stability and its credibility, the Federal Reserve may have to accept higher unemployment and lower output for a time in order to restore price stability, defined as 2% inflation on a sustained basis.

We will outline the investment implications of this environment in our upcoming Market Commentary titled “Don’t Fight the Fed.” The basic problem for investors stems from the fact that Fed policy and economic fundamentals are pointing toward a recession while market optimism may allow for further expansion. If the Fed restores price stability, defined by a return to CPI inflation at 2.0 on a sustained basis, it will set the conditions for an expansion and resurgence in equity prices. However, this could take longer than investors expect, and optimism could quickly fade. Consequently, investors should remain defensive, hold cash and prepare to take opportunities which will develop in 2023 and beyond.

Too Low For Too Long

First, some historical perspective. The Federal Reserve, in a desire to favor employment growth and recovery from the COVID induced recession, held interest rates too low and expanded its balance sheet for too long. The Fed thought that inflation would be temporary as the recovering global economy resolved supply disruptions and labor returned to work.

The view of temporary inflation has proved half right. Goods prices have peaked and are falling, though the process has taken longer than Fed leaders anticipated. In its December (latest) inflation report, the Department of Labor reported that the core Consumer Price Index had fallen to 5.7% and was clearly on a downward path. Absent any further disruptions, we expect this path to continue, and the goods prices will continue to fall. We outlined these factors in earlier commentaries, and our analysis has proved largely accurate.

But – goods prices are not the whole of inflation. They represent 43% of the Consumer Price Index (CPI). Most of the CPI (57%) consists of services such as transportation, dining, medical, and travel. Services are labor intensive and comprise 4/5 of US jobs, so wages heavily impact this category. Service prices are still headed upwards at a 6% annual rate. In short, the path to price stability requires a cooling in wage and ultimately services inflation, and the case for this cooling is not yet convincing.

Wages are still increasing, and labor markets are still tight. The latest unemployment report (December 2022) was a “goldilocks” report in the estimation of one labor economist. Unemployment stood at 3.5% and job growth notched 223K against a consensus forecast of 202K. Payroll growth, which averaged a gain of 375K jobs per month through 2022, has markedly slowed. Wages grew at 4.1 % (annual), down from nearly 6% annual growth in previous months. We must ask whether this perfect scenario will continue in future reports.

Labor remains scarce and there still exist 1.7 job openings for every available worker. Labor force participation remains lower than pre-COVID levels, and 2.1 million workers have not returned to the workforce. It seems that the path to cooling wages must come by moderating the demand for labor. This is the view that the Federal Reserve has adopted and that Fed Chair Powell articulated in his speech at the Brookings Institution on 30 November 2022. Other Fed governors have acknowledged the signs of moderating inflation while at the same time stressing the need for labor demand to cool.

Hope Springs Eternal

Market participants, as they have done for the last few months, reacted with optimism on the favorable inflation reports. They sparked a mini rally on hopes that favorable inflation reports and mentions of a pause to evaluate the effects of rate rises would be followed by a fall in interest rates. The S&P 500, which closed 2022 and traded the first week of 2023 with a 5.3% decline, recovered nearly all its losses by January 23^rd and has continued to rise. While the rebound in stock prices is good news in the short term, it complicates the Fed’s aim by loosening financial conditions when the goal, in actuality, is to tighten them. This “push-pull” illustrates the delicate nature of engineering a soft landing… something the Fed has scant history of achieving.

The Fed leadership responded to these conditions with admonitions that the central bank remains focused on price stability and that as a consequence, interest rates would have to remain elevated for some time until there was solid evidence of a return to 2% inflation.

It should not be lost on investors that most of the senior leadership of the Fed came of age during the Volcker years, so we can expect them to avoid at all costs the error of giving up the fight prematurely.

In the backdrop of these developments, the Federal Reserve continues to quietly reduce the size of its balance sheet at a rate of $95B per month. Some studies estimate that this translates to an additional 50 – 100 basis points of upward pressure on interest rates. Should the Fed continue this policy through 2023, this will remove more than $1.1B of demand for treasuries from bond markets. This will create additional tightening and upward pressure on interest rates. In sum, monetary policy is sharply contractionary and while yields have fallen over the past several months, upward pressure on interest rates remains.

Fiscal policy, by contrast, remains expansionary even as the massive COVID stimulus packages wind down. The Fiscal 2023 omnibus budget package increased discretionary spending by 9%. The flagship Social Security program includes an 8.7% increase in benefits payments to offset inflation.