Fed Policy — Dancing Between Raindrops — Fed Tightening and Fiscal Policy Drag Tests 2023 Economic Outlook — Wage Pressures a Secondary Inflation Impact Could Lengthen Higher Inflation — Accelerating World Food Inflation Could Affect Emerging Market Debt Obligations — Fixed Income View Change

Current High Levels of Inflation—effect Broadening

According to the Cleveland Fed, the median Consumer Price Index (CPI)  provides a better sense of  underlying inflation then either headline CPI or CPI excluding food and energy. Median CPI, represented in Figure 1 by the orange line, shows half of CPI components experienced annual price gains of 4.9% or greater---the highest rate since the late ‘80’s. In response to these readings, the Fed responded more aggressively.

Figure 1

Median Consumer Price Index—March 2022

SOURCE: BUREAU OF LABOR STATISTICS, FEDERAL RESERVE BANK OF CLEVELAND, HAVER ANALYTICS

Multiple Fed Funds Rate Hikes---quantitative Tightening (Qt)—goal--keep Inflation Expectations Down

Beginning at its May 3- 4 meeting, the Fed will begin raising  temperatures on its policies to lower thermometer readings on inflation. At that meeting, the Fed will likely double the funds rate to 50 bps. A series of funds rate increases—including potentially more 50 bps hikes-- will likely follow at the five remaining meetings this year as well as into 2023.   The Fed will also begin to  reduce or rundown its balance sheet—Quantitative Tightening (QT). The passive balance sheet runoff will total  approximately $95 billion monthly comprising $60 billion of Treasuries and $35 billion of mortgage-backed securities.  With the rapid rise in mortgage rates, it seems unlikely that the Fed can passively reach its runoff target for mortgage backs of $35 billion monthly. Further along, the Fed may then actively sell mortgage backs.  Overall, the Fed’s more aggressive steps may hold off the danger that currently anchored lower long-term inflation expectations rise up to meet higher short-term expectations (see Figure 2.)

Figure 2

Consumer Inflation Expectations—1 Yr and 3 Year

Fed Dancing Between Raindrops to Achieve Both a Soft Landing and Reduced Inflation

Chair Powell remains comfortable that, despite rate increases and QT, the U.S. economy will achieve a soft-landing.  He bases this expectation of strong labor markets and excess consumer savings. Nonetheless, the Fed will be dancing between rain drops to successfully achieve both continuing economic growth and lowering inflationary forces.  Monetary policy changes normally impact the economy with long and variable lags. At the same time the Fed shifts to a tighter policy stance, fiscal policy will also act as a drag on economic growth.  The fiscal drag reflects reduced COVID stimulus spending. The Hutchins Center at the Brookings Institute estimates that fiscal spending will act roughly as a 2-3% annualized drag on 2022 quarterly GDP results (see Figure 3.)  Therefore, 2023  will likely test whether or not the U.S. economy can achieve a soft-landing, reduce inflation, and avoid a recession.

Figure 3

Quarterly Fiscal Impact Measure--% Impact on Gdp Growth

SOURCE: HUTCHINS CENTER, BUREAU OF LABOR STATISTICS

Peak Inflation?

Investors reacted positively when core monthly March CPI showed sequentially lower inflation than in February.  In addition, year-over-year comparisons will likely begin looking better when compared against increasing rates of inflation in 2021. With that, investors hoped that we reached peak inflation. Briefly looking back at how we got here may give some support for investors’ hopes. In early 2021, various federal government stimulus programs led to consumers’ demand for goods shooting up and creating a rare “V” shaped economic recovery. Supply chains then backed up and inflation accelerated. With very low inventories and limited incoming supplies, retailers and suppliers responded as expected--over ordered. Today, as supply chains gradually open up, the reverse will likely happen. The “bullwhip effect” will lead to increasing inventory stocking--admittedly from very low levels. Figure 4 shows just that with the building of real retail inventories. However, increasing  inventories may not flow fully into end sales. Instead, retailers and suppliers may also build “just in case” inventories in reaction to their recent supply chain nightmares. Therefore, such rebuilding may not prove as beneficial to moderating goods pricing as past history might suggest and investors hope.

Figure 4

Real Retail Inventories—ex Motor Vehicles—cpi Adjusted-($ Billions)

SOURCE: FREIGHT WAVES

Wage Pressures—a Secondary Impact of Inflation—slows Moderation of Inflation

Higher wage pressures do not act as the initial force broadly pushing up inflation. Instead, wage pressures result as a secondary effect (see Figure 5.)  Its secondary effect will likely extend higher inflationary pressures by offsetting moderating goods inflation. Despite rising hourly wages, higher rates of inflation resulted in lower real earnings (see Figure 6.)  With that, workers real purchasing power eroded.  In reaction, consumers will likely move down from  premium priced  to popular priced branded products and, in many cases, shift to even lower priced supermarket or private brands. In addition, they will likely purchase less. Overall, wage pressures will likely lengthen the time the Fed will need to aggressively curb inflation.

Figure 5

Median Wage Growth Tracker---overall Unweighted---Paid Hourly

(1983-present—3-month Moving Average)

SOURCES: CURRENT POPULATION SURVEY, BUREAU OF LABOR STATISTICS, ATLANTA FED  

Figure 6

Average Annual % Change Median Weekly Real Earnings

SOURCE: U.S. BUREAU OF LABOR STATISTICS, ST. LOUIS FED ECONOMIC

War in Ukraine---Global Food Inflation---higher Food Costs Could Stoke Increased Populism and Arab Spring Redo— Potential Impact on Emerging Market Debt Obligations

The war in the Ukraine will add significant inflationary price pressures to global food supplies. The Food Price Index of the  United Nations Food and Agricultural Organization (FAO) reached an all-time high as a result (see Figure 7.) Russia ranks as the leading global wheat exporter while Ukraine ranks number five. In addition, Russia ,which leads the world in fertilizer exports, suspended their export shipments.  As a result, prices of all fertilizer categories more than doubled when compared to a year ago. Initially, higher food costs resulting from the war will primarily impact less developed countries. Rapidly rising costs to feed their populations may make it difficult for some emerging market countries to meet their debt obligations. For next year’s growing season, if fertilizer shipments remain crippled, higher food costs will likely produce a broader global impact than this year.  Ultimately, the impact will come home and  effect 2023 headline food inflation numbers in this country.

Figure 7

Fao Food Price Index

SOURCE: FAO

Long-term Labor Shortages and Wage Pressures Lead to Technology and Digital Capital Investments—results in Competitive Advantage--improved U.S. Productivity?

Economic growth depends on work force and productivity growth.  The U.S. faces the slowest labor force growth in fifty years—likely bringing higher wage pressures for the long-term (see Figure 8.)  But counterintuitively, wage pressures and labor shortages could lead to increased productivity over time—possibly offsetting slower workforce growth. The answer to improving productivity will likely come from increasing investments in  applying technology and digital solutions. To gain that advantage, larger corporations will likely look to smaller companies to provide such new technologies and digital services. If not yet trading in public markets, then many of these entrepreneurial companies will be financed through venture capital.   Ultimately, in this high cost labor short environment, applying technology and digital services to improve productivity will provide the key for companies to achieve both a competitive advantage and increased profitability.   

Figure 8

Labor Force Growth by Decades—1950’s—2020’s (% Growth) 

SOURCE: BUREAU OF LABOR STATISTICS, CONGRESSIONAL BUDGET OFFICE, AXIOS VISUALS

Investment Conclusions

Equities—Economic Slowing—Energy—Security--Displacement and Replacement—

Economic Slowing—Less accomodative monetary policies will likely produce an economic slowdown later this year and into 2023.  Therefore, investors will likely selectively seek out economically defensive stocks in such sectors as health care, consumer non-durables, and quality copanies that can show earnings and dividends growth through this period.

Energy--The “Putin Shock” could lead to rethinking of energy security, electric generating systems reliability, and an updating of  realistic “Green” planning to reach its necessary economic scale.  Those changes could result in expanded investments in the energy industries including fossil fuel, “Green,” and nuclear.  Businesses servicing those industries should benefit.  

Security--The growing security “alliance”  between the two great Eurasian powers—China and Russia-- will likely prove beneficial to companies supplying defense and cybersercurity equipment and services. The Ukraine war will prove a testing laboratory for advanced combat weapons. Both domestic and non-U.S companies will likely gain investors attention.  

Displacement and Replacement--The “Putin Shock” will also lead to a broad list of displacements and replacements.  For example, uncertain grain and oilseeds production from Russia and Ukraine should benefit companies broadly providing increased productivity systems and equipment to the global agricultural industries.  The same will also be true for deveoping new sources of  key hard commodities. In the later case, new sources of key hard commodities will prove critical to meeting demands from  alternative energy and electric vehicle industries.

Fixed Income and Alternatives—View Change--Our prior Commentaries suggested long-duration fixed-income investments would prove unattractive during a period of high inflation and historically low interest rates—and so far that view proved correct. Now, with aggressive actions by the Fed to bring down inflation, economic slowing will likely follow.  A slowing economy will, over time, increase the attractiveness of longer-dated fixed-income securities.  A select group of alternative investments also fits for that portion of the portfolio historically committed to fixed income.