This Too Shall Pass

Has the inflation worm turned? It’s still early, but the signs are encouraging, as an expanding list of price measures points to slower increases. Whether this favorable trend continues is an open question, as the many factors that underpinned the inflation cycle of the last two years don’t fit into conventional economic models. This is not a garden-variety demand/supply imbalance that traditional policies are designed to handle. Instead, the economy has been blindsided by a barrage of surprising external shocks linked to the pandemic, a disruptive war, and climate changes – all of which continue to wreak havoc on prices. Indeed, the drying up of the Mississippi River – a significant transportation conduit in the U.S. – is just the latest reminder to expect the unexpected.

Notably, the stakes are high if the inflation spiral is not adequately tackled. Millions of savers would see the purchasing power of their nest eggs shrink as they enter their golden years. Worker paychecks would not buy as many goods and services as before, resulting in lower living standards. A broadening swath of the population would be shut out of the housing market and unable to make other big-ticket purchases due to an inflation-induced climb in borrowing costs. More generally, once inflation becomes firmly entrenched in the economic landscape, it inevitably brings on a policy response that sends the economy into a recession, throwing millions of workers out of jobs.

The good news is that policymakers are of one mind regarding the dangers unchecked price increases pose to the economy. Inflation was a key campaign issue in midterm elections, and neither Congress nor the administration is advocating comprehensive tax or spending policies that would worsen things. Importantly, the Federal Reserve, which controls the critical tools to fight inflation, is firmly committed to reining it in, adopting the most aggressive rate-hiking agenda since the 1980s. As long as this policy backdrop stays in place, there’s a good chance the war on inflation will be won, although it’s unclear how much damage to the economy is necessary to win the battle. The wildcard is the behavior of those external influences over which policymakers have little control. But even on that score, prospects are becoming more favorable.

Inflation Spikes Are Usually Brief

Following nearly two years of escalating inflation that has overshadowed just about every other economic concern of Americans, it may seem that we have entered an era when outsized price gains are considered normal, but history suggests otherwise. Sharp upward inflationary spikes are unusual. Between 1955 and 2021, there have been only eight instances of comparable inflation spikes. Encouragingly, following each of those surges, inflation fell sharply and remained low for extended periods.

While it is widely expected that inflation will decelerate, the speed at which it will decline is highly uncertain. It’s also unclear how far from the current 7.7% inflation would have to slow before the Federal Reserve pivots from its aggressive rate-hiking campaign. If the retreat towards the Fed’s 2% target is slow and gradual, the Fed could well decide that more of a push is needed; at best, it could decide to pause and keep interest rates at elevated levels for a prolonged time. But if inflation falls rapidly, Fed officials will likely decide to start cutting rates in 2023.

Against this backdrop, it makes sense to look at the behavior of inflation after previous inflation spikes as a guide to what might plausibly happen next. These earlier spikes occurred in two distinct phases. The first cluster occurred in the 1960s and 1970s; each of those spikes was followed by a temporary decline in inflation and then by another upward surge that resulted in a higher peak inflation rate than the previous one. The other three spikes occurred after the Fed established an inflation target, and their peaks to troughs were far smaller. What’s more, inflation stayed elevated for shorter periods, and the subsequent declines took the inflation rate below 2%, although only very briefly, following the 2005 spike. The post-2008 retreat was the only period with a substantial and sustained undershoot of the Fed’s 2% inflation target.

Then And Now

From our lens, the last three inflation episodes are a better guide to the likely behavior of inflation over the next several years. Today’s economy looks much more like it did, beginning around the turn of the century than in the 1960s or 1970s. Unlike those earlier episodes, the Federal Reserve has elevated the importance of taming inflation as a policy goal, explicitly setting a 2% target since 2012. In the 1960s and 1970s, the main emphasis was on achieving maximum employment. For the Fed, public perception is vital; if the public believes the Fed is determined to hit its inflation target at any cost, inflation expectations are more likely to remain in check.

Additionally, labor had a much more significant influence on price-setting arrangements in the 1960s and 70s than now. A much larger fraction of the workforce was unionized, and cost of living adjustments (COLAs) embedded in worker pay were far more prevalent. Finally, the U.S. is more interconnected with the global economy than 40 to 50 years ago, and outsourcing workers and production has gone a long way toward keeping prices low.

And while the last three inflationary episodes had their differences, the current upsurge resembles 2008-2009. Both have been global – inflation overseas is far worse than it is in the U.S. – reflecting surging energy and food prices. That said, there is one crucial distinction between now and the last three occurrences. The earlier episodes were more narrowly concentrated than the current inflation spike. Indeed, excluding food and energy, the so-called core inflation rate stayed reasonably close to the Fed’s 2% target during the last three inflation surges. In 2022, however, the core rate peaked at 6.6% and is still running at an elevated 6.3% pace as of October.

Broader Inflation

Not surprisingly, when food and energy prices fell in those earlier episodes, headline and core inflation coalesced at low levels. That’s unlikely to happen now because the inflation surge this time has been much broader. Indeed, the share of components in the core basket of goods and services experiencing very high inflation is substantially greater today than in 2008. Almost as big a share of the core basket currently has an inflation rate of over 15% as below 3%.

Hence, if volatile food and energy prices were to collapse –a possible but not likely prospect – we would see a collapse in the headline inflation rate but not in the core inflation rate. That would be a welcome development for the millions of households that spend outsized portions of their budgets on food and gasoline. But it would not satisfy Fed officials who recognize that price changes on the broader basket of goods and services – the core group – are more reflective of underlying inflation trends.

It’s critical, therefore, for those stickier prices to start slowing from their current elevated rate as well. Unfortunately, most of those items are for services that are more labor intensive and in less productive industries, such as restaurants, medical services, and, most importantly, housing. Even if demand for these services weakens, prices would be slow to respond. Employers, for example, may lay off workers, but they rarely, if ever, slash wages. Meanwhile, people need a place to live. If home prices become too expensive, would-be buyers turn to rental units. Unsurprisingly, high home prices and surging mortgage rates have done just that, sending rents sharply higher. And since rents account for an outsized 40 percent of the core CPI, it has been a major driver of inflation.

What To Expect

Despite the difficulty in reining service prices, there are compelling reasons to expect core inflation to decline in 2023. It is often argued that the best cure for high prices is high prices. With housing becoming unaffordable for an ever-broadening swath of the population, home sales have collapsed, and home prices are declining. In time, this will filter through to the rental market; indeed, there is evidence that rent increases on new leases are decelerating and even rolling over. This trend is expected to continue next year, dragging down core CPI.

The Fed’s rate-hiking campaign – which contributed to a doubling of mortgage rates this year to their highest levels in over 20 years – is playing a major role in slowing the rise in housing costs. Meanwhile, the Fed is getting help from the easing of external forces that have stoked the inflation embers over the past year. Supply chain bottlenecks are clearing up. Shipping costs are plunging. Commodity prices are declining. And, improving health conditions are helping the labor market. In response, goods prices have rolled over as consumers have shifted spending from material items purchased during lockdowns to in-person activities.

So far, however, higher interest rates have put little of a dent in demand outside of the housing sector. Consumers are still spending at a lofty pace, as evidenced by the stronger-than-expected retail sales for October, while business plans for capital spending remain robust. This means more rate hikes are on the way as the Fed strives to cool off demand pressures fueling inflation, raising the odds of a recession next year. The good news is that the forces underpinning consumer and business spending – healthy household balance sheets, a strong labor market, and substantial corporate profits – should also cushion the severity of any downturn. Importantly, they even keep a narrow path open for the desired soft landing – curbing inflation without inducing a recession – that the Fed still hopes to achieve.

If you are a Legacy client and have questions, please do not hesitate to contact your Legacy advisor. If you are not a Legacy client and are interested in learning more about our approach to personalized wealth management, please contact us at 920.967.5020 or info@lptrust.com.

The information contained herein is for informational purposes only and does not constitute a recommendation or advice. Any opinions are those of Legacy Private Trust Company only and represent our current analysis and judgment and are subject to change. Actual results, performance, or events may differ based on changing circumstances. No statements contained herein constitute any type of guarantee, nor are they a substitute for professional legal, tax, or other specialized advice.