In late November, Federal Reserve Board Chair Jerome Powell indicated a desire to cut back on the Fed’s accommodative monetary policy as the economy seemed to be returning to “normal” after almost two years in a pandemic. In a little more than two months, the markets have responded by raising interest rates across the yield curve and pricing in as many as seven twenty-five basis point increases by the end of 2022.
The Fed’s playbook to combat inflation dates to the 1970s when Paul Volker repeatedly hiked short-term interest rates until they exceeded long-term rates and the rate of inflation. This gave consumers an incentive to save rather than spend, which reduced the velocity of money flowing through the economy.
This time around, the solution may not be quite as simple. A portion of the current inflation issue was caused by stimulus payments to consumers and businesses to enable them to keep spending through the pandemic-induced shutdown of the economy. But now, those payments have stopped, and savings balances have started to dwindle, yet we see continued signs of inflation. Rather than a monetary phenomenon, we believe the root causes of inflation lie in supply and demand imbalances.
Goods ranging from semiconductors, to oil, to steel, to coffee, have all increased in price. In our view, none of these are directly related to monetary policy. Semiconductor fabrication facilities were shuttered during the pandemic, creating shortages. Policies shutting down pipelines have prevented oil and gas from flowing to where it is most needed. We had tariffs on steel imports from Japan which caused higher prices on that commodity. Droughts in Brazil have caused shortages of coffee beans. Of course, there is also a shortage of truckers to transport the available goods. In our view, all of these have played a more significant role in inflation than monetary policy.
In addition to the supply and demand imbalances stemming from labor shortages and supply chain disruptions, it is important to consider the base effect on the inflation figures that have recently been reported. As simple as it may seem, the calendar also plays a role in the headline inflation figures.
Think back to the spring of 2021. We were just beyond the one-year mark from the massive shutdown of the economy in March of 2020. The monthly inflation figures reported in March, April, and May of 2021 were compared to the same months one year earlier. We were comparing a period when the economy was starting to reopen to a period when most consumers were hiding indoors and not spending money unless they were among the fortunate few who were at a store when a shipment of toilet paper or bleach wipes arrived. So, it makes sense that the figures from the spring of 2021 were elevated when compared to the same time in 2020.
In April of 2020, the front month futures contract for WTI Crude Oil dropped $55.90 per barrel to close at a negative $37.63. You read that correctly! Supply exceeded demand by so much that sellers had to pay buyers to take the oil off their hands. That was an anomaly and reflected unsustainably low oil prices. It’s no wonder price levels reported in April of 2021 showed a big jump from the year before.
Fast forward to 2022. We’re now going to surpass the inflation figures from spring of 2021, and while inflation may show signs of moderation, it’s only because the change from last year to this year is more modest than the change from 2020 to 2021. At the same time, the annual inflation rate that is reported will reflect twelve months of the largest monthly increases seen since the early 1980s.
But, with each successive month, the new figure is likely to show a smaller increase than the same time last year. And with the replacement of a large number from 2021 with a smaller number from 2022 in the rolling 12-month calculation, we expect to see inflation moderate this year.
Fortunately, or unfortunately, it appears the Federal Reserve is likely to begin reducing their asset purchases and hiking interest rates around March of this year, too. As already stated, we believe the inflation issues are more closely related to supply chain shortages and base effect calculations than monetary policy. Nonetheless, we expect many to link the tighter policy to a reduction in inflation.
As of this writing, the Fed Funds Futures markets—a market-based estimate of future Federal Reserve policy rates—is pricing in seven 25 basis point rate hikes this year. In addition, the Fed has announced they will not reinvest the maturities of the assets on their balance sheet—a process being dubbed quantitative tightening or QT.
Time will tell whether the Fed’s actions match the current market-based expectations. But in our view, if the Federal Reserve does hike rates by 175 basis points while they allow their balance sheet to run off, they would cause significant damage to the economy. We expect to see some rate hikes this year, but we’re much more sanguine on the total level of rate hikes. We believe the moderating inflation data will give the Federal Reserve the ability to remove their accommodation measures more slowly and will allow the current economic recovery to continue for a while longer.
Greg S. Hansen
Managing Director of Trust Investments