Not transient; Not secular – Let’s call it “SECULATORY” – Saratogian
Life – often there is little change in our daily comings and goings.
Sometimes this change can be measured in inches or gradually and once in a while life changes in an instant and alters our existence forever. Many would agree that the health, financial, political, social and societal repercussions arising from the pandemic would fall into at least one of the latter two. The intention of this column is to focus on financial changes, particularly with respect to inflation as well as the Federal Reserve’s duties with respect to the Consumer Price Index (CPI), a measure inflation at the retail level.
In 1977, Congress passed the Federal Reserve Act and, in doing so, directed the Federal Reserve’s Open Market Committee to “maintain long-term growth in the monetary and credit aggregates commensurate with long-term potential economy to increase production, so as to effectively promote the objectives of maximum employment, stable prices and moderate long-term interest rates.
Until 2020, the charges described above have undergone little change. However, in response to persistently low inflation, on August 27 of the same year, the mandate was changed as follows. “Employment, inflation and long-term interest rates fluctuate over time in response to economic and financial disruptions. Monetary policy plays an important role in stabilizing the economy in the face of these disturbances. The primary means available to the Committee to adjust the stance of monetary policy is to change the target range for the federal funds rate. The Committee believes that the level of the federal funds rate consistent with maximum long-term employment and price stability has declined relative to its historical average.
“As a result, the federal funds rate is likely to be constrained by its effective lower bound more frequently than in the past. Due in part to the proximity of interest rates to the lower bound effect, the Committee considers that the downside risks to employment and inflation have increased.
To paraphrase, the economy can operate closer to full employment than originally thought without causing inflation to spike. This conclusion drawn by the Fed was the result of a nearly decade-long inflation rate that was well below the Fed’s 2% annual target. Proof of this is that, for the decade ending December 31, 2020, inflation as measured by the CPI rose by an average of 1.75% per year, the lowest rate of annual increases since the 1930s. when prices fell an average of 1.30% per year. This is despite the fact that the yield on ten-year US Treasuries rarely exceeded 3.00% during this period.
Then, in March 2020, the pandemic hit and prices fell sharply. In April 2020, the consumer price index (CPI) fell by 0.4%, its biggest monthly drop in more than sixty years (1957). Beginning around the same time and continuing to this day, the Federal Reserve through the US Treasury and authorized by Congress, this presidential administration and the previous one embarked on a massive stimulus package, totaling trillions of dollars and consisting of monetary stimulus, a low interest rate environment, the purchase of US Treasuries, mortgage-backed securities and loan forbearance programs.
Add to that pent-up demand, early retirements, health or family related resignations and you have a recipe for inflation.
The question is whether or not this inflation will be short-lived (transitory) or longer-term (secular) as it embeds itself in the economy and expectations of higher prices in the future rise. We believe there are components of both – ergo “SECULATORY”.
We reach this conclusion by looking at the three basic components of production, manufacturing, logistics (shipping), and labor. From now on and assuming that the current social problems do not become widespread (see the blockade of the Ambassador Bridge in Ontario), we believe that the inflation of the first two components of production will decrease. Fortunately, however, individual labor costs will continue to rise, which should, in turn, contribute to economic growth, as most of these earnings will be used to purchase goods and services.
We write individually because, overall, we believe rising labor costs will eventually be mitigated as the disinflationary impact of technology that has caused the low rate of inflation over the past 2010s will begin to reassert itself. Nevertheless, we expect an inflationary environment in the range of 2.50% to 3.50%, similar to the first decade of this century and not like the 1970s, a period of runaway inflation.
Given the rise in the two-year U.S. Treasury to around 1.50%, the bond market is already pricing in six 0.25% hikes in the federal funds rate, the rate at which banks borrow excess reserves held at the Federal Reserve. Given that we believe runaway inflation is not currently a concern, we believe the Fed should take a measured approach. Whoever is deemed too aggressive may very well cause a recession.
This potential is already evidenced by the flattening of the yield curve.
Ultimately, during the second half of 2022, with a partial rectification of the manufacturing and logistics component of production, the disinflationary impact of technology as well as the process of quantitative tightening (QT) from next month, the Federal Reserve should be able to at least begin to substantially rein in recent price increases.
For equity investors, we recommend using a barbell approach. On the one hand are investments that pay dividends and perform well in an interest rate environment as described above, and secular producers on the other. Looking at fixed income, at least for the next quarter or two, expect continued pricing pressure as short-term yields trend higher.
We would also use market weakness rather than market strength to deploy additional capital as we expect continued volatility.
Please note that all data is for general information purposes only and does not constitute specific recommendations. The opinions of the authors do not constitute a recommendation to buy or sell the stocks, the bond market or any security contained therein. Securities involve risk and fluctuations in principal will occur. Please research any investment thoroughly before committing any money or consult your financial advisor. Please note that Fagan Associates, Inc. or related persons buy or sell securities for itself which it also recommends to its clients. Consult your financial advisor before making any changes to your portfolio. To contact Fagan Associates, please call (518) 279-1044.