Rates Rise, but Much Remains Uncertain
“Everybody knows that pestilences have a way of recurring in the world; yet somehow we find it hard to believe in ones that crash down on our heads from a blue sky. There have been as many plagues as wars in history; yet always plagues and wars take people equally by surprise.”
-Albert Camus, The Plague
Wednesday Chair Jay Powell increased the Federal Funds Rate, the price of money in the world's largest economy, by one-quarter of one percent (.25%, or twenty-five basis points.) This decision was not untelegraphed. Every Chair of the Federal Reserve has her or his own philosophy about how to do the job. Legendary Inflation Slayer Paul Volcker preferred brute force. Alan Greenspan, serial bubble-blower, was known for a mandarin inscrutability. We once characterized Chair Jay Powell as "The Unaccommodating" when he and the Federal Reserve Board of Governors last tightened monetary policy in 2018:
It seemed to goodstead at that time that a gradual increase in the Fed Funds Target Rate was the correct approach; inflation was quiescent, growth was good, and the Fed needed to put the economy on a more normal interest rate footing to have ammunition to lower rates when a future decline in growth rates warranted it. Policy accommodation was not appropriate at the time, nor is it now, given high employment, robust growth, increasing price inflation, high system confidence, and the desirability of incremental progress toward the neutral policy rate.
Despite the modest increase--which certainly won't impact borrowing and lending decisions much, if at all--the market exhaled a sigh of collective relief because Powell's accompanying remarks intimated that the Federal Reserve takes price stability (read: normal inflation) seriously and is set to increase rates ten times (to 2.5%) over the next two years. This would be a level consistent with what most economists consider to be the neutral policy rate. He also maintained the Federal Reserve's flexibility in setting future policy by indicating that they would react to events as they unfold.
Now that the word "transitory" has been retired from the Lexicon of Approved Economic Descriptives, goodstead will instead refer to higher inflation in the short-term as "short-term". Transitory seemed like an excellent way of describing elevated price levels that are due to temporarily reduced productive capacity and elevated aggregate demand, but since this apparently is not what "transitory" actually means, we relent.
Consumer inflation expectations are an important indicator of expected inflation since they are the protagonist (antagonist?) in the wage-price spiral drama at the heart of our moral theater. As you can see in the chart above, consumers expect inflation of 6% in the next year--which is probably on the money. Critically for the long-run health of the economy, they also expect these to moderate over the longer term. Workers may ask employers for a higher cost-of-living increase than perhaps they ordinarily would, but also may realize that this is a temporary--"short-term", as it were--state of affairs.
Short-term inflation has continued to trend higher, and its rate of change has accelerated since last year. Levels matter less than rates of change because it is inflation's impact on behavior and expectations, rather than prices themselves, that is most important; expected inflation--not inflation itself--is the Destroyer of Wealth. Worst, price inflation is most inimical to the lower-income distribution, whose spending is disproportionately comprised of food, energy, and housing. For these folks, it doesn't destroy wealth; it destroys the quality of life. The Federal Reserve's preferred measure of inflation, the Personal Consumption Expenditures Index, showed an increase of 6.1% from the prior month. While still high, one can see from inspecting the below graph that the rate of change has leveled off.
The print is of January's level, prior to the Russian invasion of its neighbor Ukraine. Since that time sanctions against the Russian regime have been implemented that have resulted in energy price increases that will most certainly push inflation higher in the short term. We get our next read on March 31st, and we expect to see a substantial increase in inflation due to the impact of geopolitical factors on food and energy, the two most sensitive components of inflation. Absent these effects, we expect the moderation in consumer demand due to higher prices, the amelioration of supply chain constraints due to logistical flexing, the diminishment of wage growth, and the higher level of inventories due to corporate stocking to relieve pressure on inflation. These will be swamped by the food and energy impact, but will be evident in measures that focus on core price change.
The Dallas Fed produces just such an analysis, the Trimmed Mean PCE Inflation Rate. It uses a method of statistical smoothing to reduce the noise-to-signal ratio. While PCE itself shows moderation in the pace of inflation, the Trimmed Mean PCE Inflation Rate shows an increase of 3.53% from the prior year--exhibiting no moderation in the rate of increase. Of course, a 3.53% inflation rate is uncomfortable but not existential; so while it is a cause for concern, it's not the level at which one starts hoarding gasoline and foodstuffs. This rate will rise in February as well, and it is the measure that has the Fed's attention. We'll check back in here on March 31st with an update.
US GDP growth has continued to be a bright spot in what has otherwise been a difficult investment environment. This is real growth, meaning that it already takes into account the impact of the change in inflation. These are growth rates that we have come to associate with China rather than the United States and at 5% on an annualized basis argue for an equity-centric portfolio.
goodstead manages largely passive portfolios for its retail clients as we believe that a well-diversified portfolio of investments that tracks the broader market return is the most efficient way of building wealth over time. As such, our portfolios include exposures that retail investors at our hidebound competitors don't or deem too risky for the average investor. We consider a modest allocation to commodities, for example, to be a necessary element in a balanced portfolio, especially in an equity-centric one. Our efforts at portfolio construction have been well rewarded in the current environment, as commodity prices have moved higher alongside inflation-linked bonds and value-factor equities. Given the continued upward trend in inflation, threats to growth, rising interest rates, and the elevated uncertainty of regime instability, we maintain a defensive, yet opportunistic posture in our core investment models. We hope that our clients take comfort in knowing that, because we have the humility to acknowledge that we cannot know the future, we have constructed portfolios engineered to weather uncertainty.