The Fed stated in late April that it expects inflation to be “transitory,” meaning it expects the current inflation trends to pass, and the decreased purchasing power of the US dollar to be a temporary phenomenon.
But what if the Fed is wrong? What if the inflation we are seeing is a direct result of the current fiscal policy of the United States government, and we are in the early phase of an inflationary environment?
The Consumer Price Index (“CPI”) is an index of the cost of goods and services consumed by a typical consumer and it is used to measure the changes in price of basic goods and services here in the United States.
Core CPI recently reached 3% on a year-over-year basis, this is the highest reading we have seen in nearly 15 years, and there is no indication it will turn down in the near future. Estimates from proprietary models show the next CPI reading could be dramatically higher.
With consumer fears of rising prices at the highest levels in the past four decades, inflation can become a self-fulfilling prophecy. FOMO (fear of missing out) appears to be driving much of the demand for residential homes, used cars, and other big-ticket items.
Prices Are Clearly Rising
While the food component of the CPI is up approximately 3.5%, my personal experience is quite different than the data suggests.
When I picked up a couple of items for a party we recently hosted, I wasn’t paying attention to prices on any of the individual items because I do enough of the family shopping to “know” what things cost. I was expecting the bill to be around $50 or $60, but the actual bill was nearly $100. I didn’t need to use a scientific method to determine the actual change in food prices from a year ago, I personally experienced the impact of inflation on my own wallet.
Commodity Prices Are Rising…
Shipping costs have risen dramatically and bottlenecks in the shipping industry are driving up some commodity prices. The cost of transporting commodities like iron ore and coal is climbing as the Baltic Dry Index touched its highest level since 2010. The BDI tracks rates along various sea routes.
Corn - Corn prices are soaring due to low supplies and more transportation issues. Recent price changes are also being driven by a drought in South America, an increase in demand for corn being blended into fuel as ethanol, and an increased demand from China.
Copper prices recently soared to $10,000 per metric ton. We haven’t seen copper prices this high since 2011.
Lumber prices have also soared to more the three times their pre-pandemic levels. While recent activity shows lumber prices settling down, there’s a long way to go before we get to levels that would encourage the start of new construction projects.
Asset Prices Are Rising…
Home prices across the US were up 11% in January from the prior year. This is the largest annual gain in nearly 15 years.
Rising home prices and low mortgage rates are also encouraging homeowners to pursue cash-out refinancing, with much of that money getting poured back into home upgrades, driving up demand for materials. The last time we saw significant cash-out refinancing was 2006!
The S&P 500 is up 31% from January of 2020.
Are companies in the S&P 500 index producing 31% more income today than they were 18 months ago? Have we seen a dramatic rise in population or new family formations in the last 18 months to drive the increased demand that is driving up home prices?
Source: Marketwatch.com (S&P 500 Performance)
While inflation may be transitory, we will need to see a dramatic shift from the current trends we are observing if inflation is to return to more-normal levels.
Inflation Fears are Mixed Amongst Investors
Wall Street was looking for a clear signal in last Thursday’s inflation report from the Bureau of Labor Statistics. The core inflation rate over the past 12 months skyrocketed 3.8%, the largest increase in nearly 30 years. But the market interpreted the report as a mixed message, with bond yields dropping slightly by the close of trading.
While the data clearly showed that consumer prices are rising across the board, some market participants interpreted the data as supporting their view that the jump in inflation will be temporary.
The consumer price index rose 0.6% in May and .8% in April. Over the past 12 months, the all-items index has risen 5%, its fastest rate since 2008.
Source: Labor Department, Haver Analytics
The Fed is Shifting the Goalposts
The Federal Reserve recently shifted the language it uses to describe inflation targets. It replaced its 2% inflation target commitment with a less transparent target: “[seeking] to achieve inflation that averages 2% over time.”
This language shift seems to indicate that the Fed is now comfortable with inflation running above target to make up for past shortfalls. The language shift also seems to indicate that the Fed is not overly concerned about inflation overshooting their historical target of 2%.
The Expectation Risk
One of the risks of overshooting the Fed’s inflation target comes from consumer expectations. If consumers have rising price expectations, inflation can become a self-fulfilling prophecy. As expectations of rising prices climb, so do prices, as consumers increase demand by attempting to purchase ahead of higher prices.
The Wage Risk
If wages kept up with inflation, then consumers would not experience a decrease in purchasing power. But wages are not keeping up with inflation, so workers are getting poorer as inflation rises.
For example: In 1991, the average wage of an American worker was approximately $21,000. The median home value in the US in 1991 was $96,000 (4.6 X wages). The average wage of an American worker today is around $52,000 and the median home price in America was around $301,000 as of January of this year (5.8X wages). The average American family can afford less home today than they did in 1991 because wages have not kept place with inflation.
Source: fred.stlouis.org
The Central Bank Challenge
The challenge for the Central Bank is that it has to digest multiple data points and accurately predict how the different data points impact one another. This is virtually impossible to do.
While Central banks do a nice job of providing people with a sense of peace, that doesn’t mean they have things under control. We all want our world to make sense, so we choose to believe that there are groups of people out there who are a lot smarter than we are, who can move the dials around to maintain a steady economy.
“We need to believe we live in a predictable, controllable world, so we turn to authoritative-sounding people who promise to satisfy that need.” — Philip Tetlock
Newsflash: There is No Grand Wizard!
But our world is complex and oftentimes chaotic, and no group of intellectual elites can accurately predict what will happen in the future. The illusion of the world being predictable may bring a sense of peace to us all, but it’s falsely placed!
Daniel Kahneman, a nobel prize winning economist and psychologist, made an interesting statement on the dangers of using history to predict the future:
“Hindsight, the ability to explain the past, gives us the illusion that the world is understandable. It gives us the illusion that the world makes sense, even when it doesn’t make sense. That’s a big deal in producing mistakes in many fields.”
While the Fed may believe they can drive the economy using history as our guide, the facts are that we have radically increased the money supply, the government is raining down stimulus payments and flooding the economy with free money, and current economic policy is encouraging people to not go to work. These types of policies will ultimately have consequences on the economy and inflation!
If you’re concerned about how inflation will impact you directly, Monotelo Advisors can serve as your trusted advisor and help you determine what shifts need to be made to prepare for changing economic environments.
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