A [Narrow] Path to Transitory

Benjamin M. Lavine, CFA, CAIA, RICP
Chief Investment Officer, 3D

Has ‘Peak Inflation Worries’ finally reached the Magazine Cover Curse?

Inflation worries have definitely reached ‘Main Street’ media, but it doesn’t feel we’ve quite reached peak inflation fears yet. Despite the U.S. Federal Reserve abandoning the ‘Transitory’ term last quarter when characterizing post-pandemic inflationary pressures, the mainstream consensus of government officials and economists still cling to the notion that the 7% rise in the Consumer Price Index (the largest annual rise since 1982) will eventually revert to more normal long-term trends. Break-even inflation rates implied by pricing between inflation-protected securities versus nominal government debt (Figure 1) also see inflation settling down to 1-3% for most developed market economies.

Figure 1 – 5- and 10-Year Breakeven Rates Imply Long-Term Mean Reversion from 2021 High Levels

Source: Bloomberg (1/24/2022)

Credit to Barron’s Magazine and Timothy Lee of Full Stack Economics (@binarybits) for publishing some thoughtful articles/threads on the U.S. inflation outlook and the challenges facing the U.S. Federal Reserve as it seeks to traverse the narrow path of containing inflation pressures while not submarining the U.S. economy into recession. Credit also to the New York Times that has delved into the root causes of the latest inflationary pressures. The debate largely stems from whether cyclical pressures stemming from the supply side (low inventories, supply chain blockages, labor shortages) and the demand side (post-pandemic consumption of goods and services) will result in a wage-price spiral that will be difficult to reverse even if the cyclical supply/demand pressures eventually resolve themselves. Figure 2 from Full Stack Economics captures this debate as ‘goods’ inflation has far surpassed ‘services’.

Figure 2 – ‘Goods’ Inflation Far Surpasses ‘Services’ Inflation

Figure 3 also demonstrates how much of the ‘goods’ sector is contributing to overall inflationary pressures when compared to pre-COVID trends.

Figure 3 – Demand for ‘Goods’ Well Above Pre-Pandemic Trends Contributing to Post-Pandemic Inflationary Pressures

Whether the factors driving ‘Goods’ inflation will resolve themselves to more normalized trends remains to be seen. However, there is some reason for optimism (hope?) that the shortages and constraints on global manufacturing will be alleviated (eventually), even though the timetable for such resolution keeps getting pushed out (Figure 4).

Figure 4 – Surveyed Manufacturers Expect Supply Chain Issues to Be Resolved by End of CY2022 or 1st Half of CY2023 (Yes, These Expectations Keep Getting Pushed Out)

Source: The Daily Shot (1/18/2022)

And even if prices of intermediate inputs remain elevated, industrial producers are signaling a peak in pricing pressures that could eventually feed its way into the Consumer Price Index (CPI) (Figure 5).

Figure 5 – Will a Peak in Manufacturing Input Costs Lead to a Peak in Headline Inflation?

Assuming one believes investor psychology is heavily influenced by prevailing ‘narratives’ (which can feed into consumer behavior and sentiment), expect the Inflation Transitory proponents to shift the narrative away from ‘Goods’ and more towards ‘Services’. Figure 6 displays the U.S. CPI heatmap and component weights. Note how Shelter and Medical Services comprise nearly 40% of the overall weight. Education, Transportation, and Recreation ‘Services’ add another 15%. Core Services increased 3.7% YOY versus 10.7% for Core Goods ending December 2021. Medical and Education related components are displaying even greater levels of moderation. If the Inflation Transinistas are correct on the ‘Goods’ Inflation to eventually moderate, then the inflation spotlight will shift towards ‘Services.’

Figure 6 – Year-Over-Year Change in the U.S. CPI and Components: Shelter and Services Comprise 55% of the Overall Weight and Are Not Rising as Fast as ‘Goods’ and ‘Food/Energy’

So, the debate over the inflation outlook comes down to whether these post-pandemic spikes will end up becoming more permanently baked into higher inflation readings and whether Central Banks are too late in implementing tighter policies to stem these higher readings. The U.S. Federal Reserve has the enviable task of threading this small needle of implementing an interest rate policy that achieves price stability while maintaining economic growth. A tall order given that much of the inflationary pressures are directly outside the Fed’s control, whether raw materials production, supply chain shortages, COVID-19 infection rates, and labor availability.

But Fed policy can have a greater influence on ‘demand’ and this is where the Fed can traverse that narrow path of achieving price stability without deep-sinking the economy. In particular, Fed policy can impact the one area most sensitive to financing costs and which comprises the largest component of the basket: Shelter (a.k.a. real estate). However, the last time the Fed attempted to put a lid on housing costs, it did not end so well (2004-2007 tightening leading into the 2008 Mortgage Crisis). If Fed policy can help moderate pricing pressures experienced across real estate and housing, then this could help consumer psychology with respect to other CPI service components, assuming that the ‘Goods’ side of inflation eventually resolves itself.

Ultimately, it comes down to whether withdrawal of post-pandemic liquidity (a.k.a. a $9 trillion Fed Balance Sheet and double digit growth in M2 Money Supply) will lead to a moderation in headline inflation (led by a moderation in ‘Services’ such as real estate). This moderation may take time to play out as a withdrawal in monetary accommodation may not show up in inflation readings for another 2-3 years (Figure 7).

Figure 7 – A Post-Pandemic Spike in Money Supply May Continue to Drive Headline Inflation for the Next Couple of Years (and About that Long for a Decline as Well)

But it is this withdrawal in accommodation that may have greater investor implications than a higher Fed Funds interest rate as shades of the 2008 Great Financial Crisis and 1998 Long-Term Capital debacle continue to haunt the Eccles Building. Apart from the risk of a recession (which didn’t stop Fed tightening following the 2000-2002 Dotcom collapse), the Fed appears to be more sensitive to risks to Financial Stability or the risk of a financial contagion resulting from a contraction in Fed-induced market liquidity. That means being on Financial Contagion Watch rather than VIX watch (a.k.a. market sell-offs like what we’re witnessing today). It also means, the markets (and the Fed) will need to be patient as we all assess the fallout from the withdrawal of unprecedented monetary accommodation.

Risk of Financial Instability may be the reason why we keep seeing the Fed float ‘trial balloons’ via bulge bracket bank consensus on the outlook for 2022 monetary policy. The Fed wants to make sure that the financial system itself doesn’t blow up as a result of tighter policy, being less mindful of a blow-up in stock prices, so it will communicate its policy intentions well in advance so as to not surprise the markets (especially the more financial leveraged areas of the market). A blow up in residential real estate seems less likely than what happened in 2008 given stronger mortgage underwriting standards and a stronger bank regulatory environment. If tighter Fed policy can help alleviate pricing pressures, through Shelter and Services, without resulting in financial contagion, then we should expect the Fed to maintain its commitment to tighten policy in 2022, which is to tighten interest rates by 1% and for the balance sheet to roll-off in the 2nd half.

With that said, the Fed has given fair warning that financing costs will move higher and financial conditions for borrowing will move tighter. Most investment grade-rated corporations have taken advantage of this fair warning by terming out their debt obligations to longer maturities. Unless the Fed sees signs of financial contagion, we should expect the Fed to pursue its tightening policies. A path that is narrow but still accomplishable.

So, we would propose the Fed (and investors) be on Contagion Watch rather than VIX Watch:

  • Corporate credit spreads remain well-behaved even if off the lows;
  • U.S. dollar remains rangebound versus major trading currencies;
  • Bank risk implied by credit default swaps remains well-behaved;
  • Commodity prices have not collapsed;
  • Gold prices remain rangebound (gold can represent the ultimate ‘the Fed messed up’ indicator).


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