Next week, the Bureau of Labor Statistics (BLS) will release the Consumer Price Index (CPI), colloquially known as inflation, for March 2022. The “Street” is anticipating a reading of 1.2% for the month, which would take the 12-Month observation to 8.5%, assuming there are no revisions to previous months. This would be the highest level since December 1981, which was a long time ago.
This is important.
Currently, there is no other issue more impactful to the US economy than inflation. Period and end of discussion. The war in Ukraine is a sideshow. The lockdown in Shanghai is an afterthought. Will Smith and Chris Rock are completely irrelevant, as is Opening Day. Even Supreme Court nominations and Elon Musk buying 9.2% of Twitter pale in comparison.
We can debate why and how inflation got to these lofty levels until the sun rises in the West, and it won’t make any difference. Consumer prices are uncomfortably high and don’t seem to be “transitory,” as the powers that be have been telling us. Inflation is here, it is real, it stinks, and it has to go. This is exactly what a lot of girls at Wake Forest thought about me back in the day.
Traditionally, to combat unwanted increases in the CPI, the monetary authorities would simply increase the price of money in the economy. As it became more expensive, people would demand less of it, and economic activity would slow down. Prices would generally fall as a result. If this seems suspiciously similar to an Econ 101 supply/demand curve graph, TA-DA! Ring the bell you 10 o’clock scholar you.
Due to all the economic disruptions associated with the pandemic, the Federal Reserve took aggressively accommodative steps to ensure an adequate supply of liquidity and credit. It took the overnight lending target down effectively to 0%, and bloated its balance sheet by some $5 trillion. This had the effect of keeping a lid on interest rates as the economy stumbled from lockdown to lockdown.
As things started to normalize, the Fed continued to keep its foot on the proverbial gas pedal to ensure the recovery “stuck,” and was willing to let prices go higher while Americans got back into the workforce. Remember, the Fed has a so-called “dual mandate” of price stability and maximum employment. Let’s just say up until somewhat recently, it placed a higher priority on the later, and it has worked splendidly.
After all, the official unemployment rate is back to a pre-pandemic miserly level of 3.6%. Further, there are some 11.266 million jobs available in the US economy. This is about 4.3 million MORE than the number of officially unemployed. Obviously, that isn’t terribly intuitive, but it does drive home a basic point. We are, for all intents and purposes, at maximum employment. As such, it is time to tackle price stability.
Again, historically, this has meant making money more expensive. Since interest rates are little more than the price of money, this means the primary lever the Fed has to make money more expensive is to raise “interest rates.” The most important rate it directly controls is the target overnight lending rate between member banks. Therefore, to make money more expensive in order to decrease the demand for it and drive down consumer prices, the Fed has already embarked on a rate hike program. Voila.
The only question remaining is just how quickly the Fed will act.
With this in mind, have you ever heard of the “boiling frog” apologue? If not, the basic premise is a frog will jump out of an already boiling pot of water; however, if you gradually heat the water while the frog is in it, it won’t realize the danger until it is too late. While biologists will tell you this is demonstrably false, it does make a powerful argument: the more gradual the change, the less you will notice it.
If you can accept this, you can accept the following: the more gradual the pace of future Fed rate hikes, the less likely they are to have a dramatic impact on our behavior. Taking it one step further, the more measured the Fed is in making money in the US economy more expensive, the less likely it will steer it off a cliff or into a ditch. I hope this makes sense. That money is going to be more expensive in the near-term is a given. Just HOW expensive is still anyone’s best guess, and everyone seems to have an opinion.
So, inquiring minds want to know whether the Fed will be willing to sacrifice economic growth in order to throttle the CPI. In a nutshell, that is basically it. If that seems kind of scary to you, it is to me as well. So much so, I told a group yesterday Jerome Powell is a bigger threat to the short-term prospects of the US economy than Putin, Xi, Kim Jung-un, etc.
As I type here today on 4/8/2022, the futures market is currently ‘predicting’ an additional 9.552 rate hikes between now and the 2/1/2023 FOMC meeting. This means the “implied” rate is 2.734%, which is 2.391% higher than it is today. Obviously, that would have an impact on economic activity in some form or fashion, as it would be a pretty aggressive about-face from the Fed’s behavior of the last, well, decade or more.
However, a lot can change between now and then. Essentially, just because the futures market says one thing and NYC brokerage firm XYZ says something similar does NOT mean it will come to pass. It is one thing to predict trends and quite another to pinpoint where something will be in 11-12 months. It is the difference between probabilities and possibilities, if you catch me drift.
This is why the upcoming inflation data is so important. Right now, analysts are predicting the possibility for enough rate hikes to potentially cause the US economy some stress in 11-12 months, all other things being equal. However, IF the inflation data shows signs of cooling somewhat, for whatever reason, the Fed might be able to be more gradual in tightening the money supply, and these dramatic predictions will likely change.
Whew.
That’s where we are. Take your pick: high inflation or expensive money. Everything else in the economy is a sideshow.
Thank you for your continued support. As always, I hope this newsletter finds you and your family well. May your blessings outweigh your sorrows not only on this day but on every day, and may the conflict and bloodshed in Ukraine end quickly.
Chief Economist
Please note, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as those of our investment committee, is subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the rest of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself.