Federal Reserve Abandons ‘Transitory’ Label in the Backwash of New Inflation Readings
by Jason Vaurio, Senior Investment Research Analyst
“We tend to use [the word transitory] to mean that it won’t leave a permanent mark in the form of higher inflation. I think it’s probably a good time to retire that word and try to explain more clearly what we mean.”
-Fed Chairman, Jerome Powell, in a speech to Congress on Wednesday, November 30th.
Chairman Powell and many Fed officials have been using the word “transitory” to describe COVID-19-related inflation in the US economy since it began ticking upwards at the end of 2020. From the beginning of the COVID vaccine rollout in early 2021, we have seen inflation measures (CPI) repeatedly eclipse monthly estimates, recently posting a historic 30-year high number in October 2021 (+6.2% change from one year ago). With new data suggesting that higher inflation is no longer confined to a narrow group of goods and services, the prospect of sustained long-term inflation weighs on investors’ minds. Regardless of the bearing between today’s elevated price levels and longer-term inflation readings, when it comes to investing in an inflationary environment, a prepared portfolio is a resilient portfolio.
An Economy Awash With Demand
Many economists, both professional and armchair, forewarned the possibility of heightened inflation in the post-COVID vaccine economy. In the early stages of COVID, as factories and retail storefronts shuttered and millions of employees were laid off or furloughed, the Fed made it abundantly clear that it would do whatever was necessary to support capital markets. The Fed initiated its asset purchasing program in mid-March 2020, and has added approximately $120 billion of liquidity per month into the bond markets since that time. These liquidity injections, combined with near zero interest rates and financial support to households through direct stimulus payments and enhanced unemployment benefits, have driven money supply to unprecedented levels. Households comparatively spent less money, and when they did, opted for goods in lieu of services such as vacations, sporting events, concerts, etc. Direct cash infusions to households and reduced opportunities for services spending enabled consumers to pay down their debts at a rapid pace, resulting in some of the lowest household debt rates and highest savings rates in the past four decades. If the singular goal of the Fed and US government was to buoy consumer demand until the economy could reopen – mission accomplished.
Rising Costs Sink Ship(ment)s
The other side of the inflation equation concerns supply, and if you’ve ordered anything off the internet in the past 20 months, you’ve probably found yourself annoyed by delayed shipments and higher prices. The shift in consumer demand from services to goods amid the global economic recovery has taxed an already lean running supply chain. Producers have been strained to keep up with increased demand, with many encountering roadblocks in their attempts to re-establish pre-COVID supply relationships. Making matters worse, prices of commodity inputs have skyrocketed in tandem with demand for end-products. Producers are now competing for the limited global supply of raw materials and intermediate manufactured inputs (ex: semiconductors) with firms around the world at all levels of the supply chain. Add rising labor costs into the mix and you have a perfect recipe for high short-term inflation readings.
A Reprieve on the Horizon?
The Fed was quick to slash the federal funds rate to near zero in the early days of the pandemic. Now that the economy has snapped back and inflation remains top of mind for central banking authorities, interest rate hikes remain the most effective arrow in the Fed’s quiver. The Fed is set to begin tapering its asset purchases in December, reducing buying by $15 billion per month through mid-2022 when it will cease buying bonds. Thus, setting the stage for interest rate hikes in the second half of 2022.
A commonly-held view among economic prognosticators is that as the economy nears a fully reopened level, demand for goods will shift back to services, stabilizing commodity prices and relieving some pressure on producers and the supply chain. The timing of the Fed’s actions and absence of new vaccine-resistant COVID variants will play a key role in cooling inflation over the next 12 months. Longer-term inflation will depend on how structural changes in the economy play out.
Or Treacherous Waters Ahead?
One of the more standout developments in the sea of unprecedented scenarios that have played out since early 2020 comes from the labor market.
With the vaccine reopening underway and extended unemployment benefits expiring in September 2021, there was hope that the labor force participation rate would bounce back to near pre-pandemic levels. That has yet to happen, and may be an ominous signal for longer-term inflation. The lowest quartile (or bottom 25% of workers) have seen the most wage growth since the beginning of the pandemic, and businesses are still having a hard time filling these openings. The worry is that the low wage earner’s propensity to work has changed. In order to entice these people back into the labor force it may be necessary to increase wages even further. A business facing this scenario has two options:
- Increase wages and maintain prices, resulting in lower profit margins or
- increase wages and increase prices – in an attempt to maintain profit margins. This phenomenon is known as the “wage-price spiral.”
As the prices of goods rise, workers seek higher wages to cover the higher costs of living (including the expectation of future cost increases). As wages increase, firms are motivated to raise the prices for goods to offset additional labor costs. This price of goods/price of labor cycle of one-upmanship can be a driver of persistent long-term inflation, though it is likely that monetary and fiscal intervention will prevent an out-of-control spiral. Common Fed/government tools include interest rate hikes, Fed asset sales, tax increases and a reduction in spending. The “wage-price spiral” remains a possibility, however, and could be a drag on traditional asset class returns going forward.
Weathering The Storm
Recognizing that none of us are soothsayers who can perfectly predict how, when and for how long inflation will persist in the US economy, Oxford has long maintained disciplined allocations to strategies that aim to protect your portfolio in high inflation periods. We devote a meaningful portion of the safety elements of our strategy to inflation-protection strategies that seek to appreciate at the rate of breakeven inflation (2.5% at the end of November). These strategies may utilize CPI swaps or traditional treasury TIPS to keep pace with above-average inflation. The growth and diversification elements of the portfolio also have dedicated allocations to strategies such as real assets and futures, respectively, to capture performance in periods of high inflation and rising interest rates.
For more information on the benefits of a managed futures allocation in periods of rising prices, please see our June Investment e.Perspective from Oxford Investment Fellow and Managing Director, Dan Ford.
For many investors the current inflationary environment may feel like uncharted waters – and for good reason. 2021 and beyond threatens to be only the second 12-month+ period in the past 30 years where annualized inflation exceeds 5% (as measured by CPI). Oxford believes in well-diversified portfolios with prudent, intentional allocations to strategies designed to mitigate purchasing power loss from inflation.
Oxford Financial Group, Ltd. is an investment advisor registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Oxford Financial Group’s investment advisory services can be found in its Form ADV Part 2, which is available upon request. The above commentary represents the opinions of the author as of 9.30.21 and are subject to change at any time due to market or economic conditions or other factors. The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice. No offers to sell, nor solicitation of offers to buy any securities are made hereby. Solicitations of investments and any offers to sell securities, if any, will be made only through an offering document clearly identified as such. Certain of the statements in this document are forward‐looking which cannot be guaranteed. These statements are based on current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results or future performance to differ materially from those expressed or implied in such statements. OFG-2112-6.