Inflation has become one of the biggest buzzwords of 2021 as the U.S. Bureau of Labor Statistics (BLS) reported that the Consumer Price Index For All Urban Consumers (CPI-U) was up by 6.2 percent in the 12-month period ending October 2021. That’s the largest 12-month increase since the period ending November 1990. It’s no wonder an economics term typically reserved for financial news channels made its way to the evening news for all the major broadcast networks in the U.S.
Technically, the Federal Reserve tracks the core personal-consumption expenditures (PCE) price index. The Fed believes Core PCE to be a better measure of inflation because the price index excludes food and energy, which experience wild swings that obscure the underlying inflation trend. But even core PCE came in at 4.2 percent in October 2021, which is more than double the Fed’s 2 percent target.
Team Transitory vs. Team Persistent
Simply put, inflation is running hot and market participants as well as consumers are becoming disillusioned–or have been for quite some time–with the idea that inflation might be temporary. So where did this idea come from in the first place? The Fed first referenced the concept of ‘transitory’ inflation in a policy statement in April of this year. Several Federal Reserve officials, such as Fed Chairman Jerome Powell and Vice Chair Richard Clarida, Governor Lael Brainard, Atlanta Fed President Raphael Bostic and St. Louis’s James Bullard all publicly echoed the same sentiment. Even Treasury Secretary Janet Yellen got in on the action. And so did member of the Council of Economic Advisers, Jared Bernstein when he wrote in an April 2021 blog post that he expected the factors leading to inflation to ‘likely be transitory.’
Meanwhile, critics like former Treasury Secretary Larry Summers, former New York Fed President Bill Dudley, former IMF chief economist Olivier Blanchard, and billionaire Paul Tudor Jones warned about more persistent inflation that needed to be reined in. Despite past comments, this month, in a rapid turnaround for the most high-profile proponent of transitory inflation, Chair Powell seems to have changed his tune.
Today, in testimony before the Senate Banking Committee, U.S. Federal Reserve Chair Jerome Powell said in a surprising about-face, “I think it’s probably a good time to retire that word and try to explain more clearly what we mean.” In the face of strong inflationary pressures, Powell added it would be appropriate to discuss speeding up the taper of asset purchases at the FOMC’s Dec. 14th-15th policy meeting.
What Accelerated Tightening Means for Markets
The Fed has several options at its disposal to cool off an overheated economy. The actions that they take in the form of tight monetary policy can include raising short-term interest rates, reducing bond purchases, or rolling off their balance sheet. Given the federal government’s strong inflation print, the market fully understands the measures the Fed must take to bring in supply-demand imbalances. For the stock market, it is not a matter of ‘if’ but ‘when’ and ‘how’. In other words, the market can overlook the Fed’s tightening policy and focus more on corporate earnings, assuming the pace is well-communicated and moderate. If the market is caught off guard and/or if policy tilts more and more aggressively, financial markets could enter a correction instead. This makes the Fed’s policy meeting next month that much more important as the U.S. focuses on managing inflation without dismantling the economic recovery out of the Covid-19 crisis.
The Dow Jones, S&P 500, and Nasdaq all fell more than 1% today after Powell’s hawkish comments about potentially speeding up the pace of tapering. Additionally, comments made by Moderna’s CEO about the reduced effectiveness of Covid-19 vaccines against the new Omicron variant did nothing but increase uncertainty and worries about the outlook for markets.
Components of Inflation Outside of the Fed’s Control
While the Federal Reserve traditionally fights inflation through open market operations (OMOs), there are elements present in the existing inflationary environment that they have no influence over; namely, anomalies in the labor market and global supply chain disruptions.
Trillions of dollars in fiscal support spent in 2020’s Coronavirus Aid, Relief, and Economic Security (CARES) Act and Consolidated Appropriations Act (CAA), plus this year’s American Rescue Plan Act (ARPA) injected huge amounts of stimulus into the system. In March 2020, the Federal Reserve also set up a number of powerful emergency lending facilities to support critical market functioning and increase confidence in markets.
Businesses shored up their balance sheets, and U.S. consumer spending, personal savings rates, and investment accounts soared. These were all welcome developments but there were also some unforeseen consequences.
For starters, the labor shortage has continued, which some thought would dissipate once schools reopened and Covid-19 pandemic relief programs expired in September and October last month. Additional factors such as early retirements, child care challenges, entrepreneurial pursuits, concerns about Covid-19, built-up savings, relocations, and burnouts have also contributed to a shortage of workers. In a strong economy pumped with stimulus, businesses have struggled to hire the labor they need to meet the enormous demand. As a result, they have been forced to raise wages to attract workers. And, even still, businesses around the country find themselves unable to fill workforce gaps.
Higher wage costs could pressure profit margins, particularly in some industries within the consumer discretionary sector, which has been hit the hardest by the Covid-19 pandemic. More importantly, rising wages contribute towards inflation and an already accommodative Fed is temporarily unable to subdue wage growth in the current environment (due to changing attitudes towards work outside of their control). Although tightening policy may make sense for other reasons, raising rates against the backdrop of weak labor force participation may only lead to more problems in the labor market down the line.
Besides labor, a second contributor to current inflation levels that evades the reach of the Federal Reserve exists on the supply side. Global supply chain issues started during the onset of the Covid-19 pandemic in Q1 2020 and gradually became worse heading into mid-2021. For decades, supply chains have been optimized to manage low inventory but provide goods just-in-time, even during periods of increased demand. What made this year different once again ties back to the U.S. labor shortage. Businesses that operate ports, warehouses or transport goods (e.g., trucking, freight rail, etc.) struggle to attract and retain workers just like everyone else. It explains why there were 96 vessels anchored at sea for weeks near the Ports of Long Beach and Los Angeles last month as containers piled up on docks.
ABC7 Eyewitness News | Tuesday, October 19, 2021 | “Record number of container ships waiting to enter ports of Los Angeles, Long Beach” | by Jade Hernandez
Further, every country has a different approach towards tackling the Covid-19 pandemic within their own borders. That’s no problem when a country is enforcing restrictions “within their own borders.” But within the context of a global supply chain, chaos could ensue. And that’s exactly what’s been happening. In August, for example, China famously shut down a whole shipping terminal in the world’s third-busiest port after just one worker tested positive for Covid-19. The terminal was key to container operations as it processes 25% of the cargo that passes through the port. Covid-19 also caused another disruption at a different port in the country a few months prior. The sad fact of the matter is virtually every container port around the world is experiencing some form of backlogs and delays.
The United States has the largest consumer market in the world but consumer behavior shifted dramatically after Covid lockdowns, work-from-home measures, and remote learning all went into effect. Consumers began to shop more online versus in-person, and buy more goods than services. Cash-rich consumers, propped up by trillions in stimulus, were primed to engage in an unprecedented boom in online shopping. Such high demand combined with supply chain bottlenecks led to higher prices and scant or at times even empty store shelves. Automotive manufacturers and electronics makers suffered from a shortage of semiconductors. According to Adobe, “The prevalence of out-of-stock messages has risen a whopping 250 percent in October 2021, when compared to a pre-pandemic period (Jan 2020). […] And, in this last month alone (Oct 2021), consumers have seen over 2 billion out-of-stock messages online.”
How This All Ends
Short answer: nobody knows. Right now, too much money is sloshing around in the system chasing too few goods. With Powell’s comments come the likelihood the Fed will pursue a more aggressive policy tightening schedule through accelerated tapering (of the central bank’s quantitative easing program) and fed funds rate increases. Currently, there are a near record level of unfilled job openings, but that may change as the eventuality of depleted excess savings (built up by relief programs) force workers back into the workforce. Leverage in the jobs marketplace will shift from workers back to employers and wages may decline or, at a minimum, wage growth may slow–although higher wages are often “sticky” for businesses itching to lower labor costs on their balance sheets. Raw materials on the other hand are not as sticky and might come down for a number of reasons including a stronger dollar, relative to some emerging economies, and less accommodation coupled with slowing demand.
As for the ‘transitory’ argument, Chairman Powell claimed, “What we missed about inflation is that we didn’t predict the supply side problems.” As workers reenter the workforce and supply chain disruptions are alleviated, costs for businesses to import and transport inventory should come down. Consumer demand should also come down as the economy cools off. Container ports will eventually return to normal operations and limited supply of products should become a thing of the past. Higher supply of goods would dictate consumers will not be willing to pay for products at current levels.
So indeed, inflation may in fact end up being transitory but we may not see a reduction in inflationary pressures until late 2022 or 2023.
