By Michael J. Willms
Director of Trading and Market Research
Rising inflation and the potential for longer-term inflationary pressures have been the topic de jour in the financial media. And for good reason: Current inflation readings are exceeding the Federal Reserve’s 2% target by a non-trivial degree. What’s unclear is if the acceleration in inflation will be transitory (as the Fed Chairman Powell has been saying), or more persistent, as some leading market observers predict?
Congress and the Federal Reserve have collaborated in an effort to minimize the immediate economic impact of the Covid-19 pandemic. Those efforts have largely been successful. The unprecedented injection of liquidity into the nation’s economy, combined with the end of the government-imposed lock-down, has unleashed a nation-wide “V” shaped recovery. The economy grew at its fastest pace on record (33.1%) by the end of the 3rd quarter of 2020 and continues to enjoy a strong expansion during the first half of 2021.
With 63% of all U.S. residents receiving at least one vaccination shot, combined with Americans having money to spend, expectations are for the recovery to roll on. Personal income increased by more than $1 trillion in 2020, thanks in large measure to the third round of stimulus payments hitting consumer’s bank accounts.
At the same time, stock markets are close to all-time highs and bond yields, while up from last year’s lows, are still near historically low levels. There is a demand shock to the upside, which is the opposite of the aftermath of a recession.
Not surprisingly, prices have been rising as a result. The rebound train has had a material influence on pricing trends. For example, note that:
May’s Consumer Price Index (CPI) showed prices rising by 5% on an annual basis after seasonal adjustments, while the month-to-month gain was 0.6%.
The Fed’s preferred inflation indicator is the Core Personal Consumption Expenditures Index (CPCE), rose 3.4% in May, the fastest increase since the early 1990.
Controlling the level of inflation within the U.S. economy is one of the Federal Reserve Bank’s two main policy goals (full employment being the second). Since 1996, it has been understood among Fed policymakers that the (undeclared) target for inflation was 2% (give or take). In January 2012, Chairman Ben Bernanke made this implicit inflation target explicit, thereby aligning the Fed’s inflation target with that of all the major central banks.
This traditional construct changed in August 2020, when current Fed Chairman William Powell unveiled the “Average Inflation Target” as the new paradigm. Inflation would be allowed to exceed 2% for an undetermined length of time without a Fed response. The policy shift allowed for a catchup to the 2% target, on average, given the prolonged period of time inflation has been below the 2% target. While this policy change has given the Fed some much needed breathing room, it has done little to abate inflation concerns on Wall Street.
We all have grown skeptical of the “this time is different” narrative. But there are two unique factors at play this time around:
The recession of 2020 was not caused by a drop in income, asset price deflation, or any other destructive economic event. Rather, the catalyst for the economic contraction was the pandemic, which is more akin to a natural disaster.
Unlike all previous recessions, personal income has grown during the recessionary period through the beginning of the recovery due, in large measure, to governmental fiscal policies. By the Fed’s own estimate $2.8 trillion of excess savings have accumulated over the course of the pandemic through the start of the current recovery.
The pandemic can be thought of as a natural disaster on a national scale. When a hurricane strikes, widespread property destruction brings the economy of the storm ravaged area to a standstill. But once the storm has passed, the rebuilding begins. There may be material shortages at first, but insurance payments provide the funding needed for a V-shaped recovery. The economic contractions in the first and second quarters of 2020 were induced by hurricane-like forced government shutdowns.
With the pandemic winding down (at least in the U.S.), the urge to spend is being vividly demonstrated. Consumers seem willing to pay today’s higher prices, so as to avoid paying even more tomorrow. Whether this psychological change proves to be persistent will play an important role in determining whether inflation will be short-lived, as the Fed insists, or will prove to be more enduring.
History has demonstrated that if the inflation genie escapes his bottle, it can be awfully tough to get him back in it. In the past, the central bank could raise interest to curtail demand and rein in inflation. However, that may be much more difficult this time around, given that the U.S. has $29 trillion dollars of outstanding debt, with no obvious source of repayment.