What do you do when you set a goal and consistently fail to reach it? If you are the Federal Reserve, you change the objective. They set the first inflation target in 2012, seeking to maintain a price increase ceiling of 2% each year. In their self-assessment, they haven’t been close. So last year, the Federal Reserve changed its inflation goal to target a 2% average instead of a 2% ceiling. Their justification was to tolerate higher inflation while the economy reopens, keeping rates low to support economic activity and getting people back to work. The aim is to convince the investing public they are serious about controlling inflation, but their twisted logic becomes more strained as inflation remains at elevated levels.
As the economy reopened earlier this year, the Federal Reserve expected inflation to rise and heavily promoted the idea it would be transitory. It is now clear their definition of transitory is lengthier than first implied. Chairman Jerome Powell testified before the Senate Banking Committee on September 30 that supply chain issues will continue well into 2022.
Federal Open Market Committee voters announced on November 3 that their bond-buying program would start to taper in November 2021, while interest rates could start increasing in late 2022 or early 2023.
Inflation now exceeds overnight rates by the widest margin in 40 years. This differential is depicted in the chart below, showing CPI inflation (red line) reporting at 6.2%, against the Fed Funds rate (blue line) and the 10-year US Treasury (green line) well below that level. Financial history suggests this disconnect is unsustainable.
The risk of the Federal Reserve’s nonchalant monetary approach is elevated inflation and higher interest rates. Some of the first price spikes earlier this year from used cars, lumber, and other items associated with an abrupt reopening of the economy are indeed tempering. But prices not easily tied to reopening are moving higher and likely to pick up speed, such as housing costs, energy, and manufactured goods.
Housing prices moved dramatically during the pandemic, increasing 15% nationally. We have not yet seen similar increases in rental costs reflected in inflation indexes. A recent report from the Federal Reserve Bank of Dallas, however, suggests that housing price growth leads rent inflation by somewhat less than two years. We are there now.
Factories and service providers working feverishly to boost production and meet demand require energy, but oil and natural-gas supplies are tight. Both are near seven-year highs, heating oil is up over 50%, prices at the pump are up nearly a dollar/gallon from last year, and coal prices are at record highs. Oil exporting countries are increasing production in measured steps instead of switching the taps wide open. Natural-gas supplies have been affected by nasty weather in Texas and the Gulf of Mexico, forcing production off-line amid growing demand in foreign markets. And coal demand is colliding with carbon emission-reduction plans.
Finally, manufactured goods costs are rising. Beyond additional energy costs, manufacturers are paying higher input costs for raw materials due to increasing demand and a supply chain struggling to meet that demand. Labor costs are rising too as more employees step away from the labor force. Companies are responding by raising wages, in some cases well above the $15 minimum wages proposed before and during the pandemic.
There are four ways to reconcile the gap. First, hope inflation is transitory and declines quickly. Second, raise interest rates above the inflation rate. Third, change the inflation target again. Fourth, some combination of the above. Each option will affect asset prices, and investors should understand how their portfolios might respond.
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