Another week, another missive about inflation.
My apologies. Unfortunately, it is the most important issue facing the markets, economy and even politics. How much longer will prices remain elevated? Better put, how long will it take for the American consumer to get used to them?
The same could be said for the business world.
After well over a decade of essentially free money, current borrowing costs have come as a shock.
- Developers have postponed deals.
- Potential homeowners are balking at mortgage rates.
- There is no incentive for current homeowners to either move or refinance their mortgage.
- Credit card holders have seen their minimum monthly payment increase.
The list goes on and on.
However, historically, this is the norm. For as long as there have been financial markets, interest rates and inflation have had a strong positive correlation. This means they tend to move in the same direction. It has only been relatively recently when central banks and other monetary authorities have artificially kept the cost of money below the rate of inflation.
At least for any substantial period of time.
The markets wouldn’t allow them to do otherwise. Lenders need to see a real rate of return. After all, what investor really wants something paying, say, 2%, when prices are climbing 6%? If you make enough of those investments, you will end up eating potted meat.
As an aside, the last time I was negative about potted meat in this newsletter, which is a weird thing to type, someone here in the office took issue with me. They said: “It isn’t all that bad. I bet you have never tried it, have you?” I replied that, indeed, I had tried potted meat and that is was all that bad. To be sure, I would be happy to have the stuff during a zombie apocalypse, but, until such a time, I’ll pass.
So, the overnight rate at 5.50%? The current 10-Year Treasury yielding roughly 4.40% on May 17, 2024? With the trailing 12-month Consumer Price Index (CPI) trending at 3.4%, I might argue the interest rates are about where they should be. However, they are reversed. The overnight rate should be around 4.4% and the 10-Year Note should yield 5.50%.
I would be cool with that, and so would a lot of other people. After all, lenders don’t care what the absolute levels of interest rates are as much as the ability to make their desired spread. For instance, if a bank needs to make, say, 3% on a loan and can pay depositors 2%, it will extend credit at 5%. However, if the cost of their liabilities is 5%, they will price their loans at 8%. Of course, as always, this assumes the nebulous “all other things being equal,” and it is a little more complicated than that.
The problem is, the Federal Reserve has made it perfectly clear it doesn’t intend to start “cutting rates” until there is meaningful progress in driving down inflation towards its 2.0% target. No, the markets don’t have to wait until the trailing 12-month “core PCE deflator,” the Fed’s favored inflation gauge, actually hits 2.0%.
It will just have to see a more stable diet of 0.1% and/or 0.2% monthly observations. The question remains, when will that be? Because, until such time, banks will have to ‘pay up’ for deposits, which means potential borrowers will have to pay more than they would like, if they borrow at all.
This week, the Bureau of Labor Statistics (BLS) released the CPI for April 2024. Although the headline numbers were mostly in keeping with analysts’ predictions, 0.3%, you could almost hear a sigh of relief from the markets. The unspoken concern was that the data would be worse than anticipated, and it was a real concern.
You could almost liken it to dreading a social function. I mean, you have convinced yourself it will be a real drag. However, the event ends up being reasonably fun, even pleasant. Because of the massive gap between your negative expectations and the agreeable reality, you consider a modest success of a party as a raging blast.
Am I the only one who has experienced this??
There is little other explanation for why the markets responded as positively as they did after the CPI announcement. As I said in our Wednesday morning conference call, and I paraphrase: “in non-biased terms, this was straight down the middle of the road. There was something in it for both bears and bulls. If you wanted to see signs that inflation is cooling, it was in there. Conversely, if you think inflation isn’t going anywhere, you could find ample evidence to that end. However, the markets appear to have loved it, because it wasn’t as bad as anyone feared.”
Moving forward, I suspect this will increasingly be the case. Unless something dramatic happens, it is very conceivable to see monthly “core” inflation numbers hovering in that 0.2-0.3% range, as opposed to 0.1-0.2%. There are a number of reasons for this, which I have discussed in the past, and likely will again in the future…but not today.
This, then, takes us back to the original questions from the first paragraph.
- How much longer will prices remain elevated?
- How long will it take for the American consumer to get used to them?
The answer to the first question is both easy and necessarily vague. As long as consumer demand remains at least somewhat stable, prices, in aggregate, aren’t going to fall anytime soon. Think about it. If you can sell your product all day long at $10/unit, why would you be in a hurry slash prices? Out of the goodness of your heart? Not terribly likely, since altruism is always easier with someone else’s money and not your own.
The answer to the second one is also easy, but not as vague. Absent any unforeseen changes, I suspect it will take American consumers another 12 months, or thereabouts, to fully “get used to” the new normal. Right now, the wounds are still a little too fresh. We could accept the price hikes in 2021 and 2022 due to the hangover from the pandemic more easily. They were painful, but understandable enough. However, 2 years later and the price of ground beef is still climbing? That is a little more annoying, isn’t it?
Then, we all know inflation is going to be a hot button issue in the upcoming elections. The candidates simply aren’t going to let us forget it. As such, it is going to reside in the front of our brain through the election and the PTSD we will all have after it. This will take us into 2025, maybe all the way through January. Throw on a few extra months for safety and, voila, 12 months, or thereabouts.
Therefore, you can sum the last several paragraphs thusly: “prices are going to stay higher for the foreseeable future, but you will get used to it.”
If you can’t, you can always opt for the potted meat.
Have a great weekend.
Thank you for your continued support. As always, I hope this newsletter finds you and your family well. May your blessings outweigh your sorrows on this any every day. Also, please be sure to tune into our podcast, Trading Perspectives, which is available on every platform.
John Norris
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 well 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.