Waiting for the Pivot
The financial markets continue to be laser-focused on inflation. Price increases that were initially thought to be transitory have instead been persistent and more widespread. The Federal Reserve has vowed to bring rising prices back under control, primarily by slowing the economy through interest rate increases. When inflation shows concrete signs of receding, the Fed will pivot away from raising rates and the economic cycle will begin anew as rates level off prior to likely decreasing again. While it is too early to say with certainty, there are early signs that inflation may finally be cooling.
As the economy recovered from the pandemic, inflation accelerated last year. Low interest rates and government stimulus combined with constrained supply chains caused prices to rise. This year’s invasion of Ukraine by Russia further spurred inflation globally, impacting energy, food and other commodity prices.
Overall inflation climbed 7.7% from a year ago in the most recent Consumer Price Index (CPI) report for October. This was down from 8.2% in September and below what economists had expected. Underlying inflation trends also headed lower. Stripping out volatile food and energy prices to get a better sense of the trajectory, prices climbed 6.3%during the past year. This was also lower than the prior month and below expectations.
Some of the CPI components appear to be slowing but are taking time to show up in the monthly data. Shelter, for example, makes up 32% of the index and is split between rent (almost 25%) and housing costs (roughly the remaining 75%). This large portion of the CPI has risen substantially every month recently at a greater rate than the overall index. In reality, multiple industry reports show that rents have been subsiding month-to-month for the past few months. Additionally, much of the housing market has turned into a buyer’s market thanks to 30-year fixed mortgage rates rocketing to 7% from 3% at the end of last year. Clearly, reported CPI data for shelter expenses is lagging market conditions.
Commodity prices have also receded. The Commodity Research Bureau (CRB) Index encompasses a basket of 19 commodity products including energy, food and metals. The broad-based index is down over 15% recently from its peak in June. Demand is slowing and prices are dropping.
Asian supply chain issues caused shortages of ships, shipping containers and warehouse facilities and overwhelmed the capacity of docks to handle the shipment of goods in a timely manner. The resulting reduction of components and finished goods were some of the initial seeds of inflation. Freight costs consequently went through the roof and drove the prices of goods even higher. Shipping container freight rates have since plunged by 70% from their peak. Supply chain problems appear to be rapidly dissipating.
In addition to raising interest rates, the Fed is pulling additional levers behind the scenes to reduce inflation. During the height of the pandemic, in a process known as quantitative easing (QE), the Fed bought large quantities of government bonds and mortgage-backed securities to suppress interest rates and provide liquidity. The U.S. money supply (as measured by M2) swelled at a record rate, increasing by over 40%from February, 2020, to March of this year. Since then, the Fed has reversed the process and begun quantitative tightening (QT) by gradually liquidating some of its balance sheet assets. The money supply has shrunk since March, a huge change in direction and very anti-inflationary. For reference, the money supply has grown on average 7.1% per year over the past six decades and never declined year-over-year in any month during that period.
The Fed’s recent interest rate increases are beginning to impact inflation. We are seeing more evidence indicating that pricing pressures are easing in several areas. When this flows more broadly into the economy and the official inflation data, the Fed will pivot away from additional interest rate increases. The Fed’s monetary changes take time to filter through the economy and thus work with a lag. Therefore, it is not out of the question that the Fed would move quickly towards a neutral stance or in the other direction when they see a clear shift in the economic data, having raised rates so rapidly. The eventual leveling off and possible easing of interest rates should be very beneficial for financial markets across the board. As the markets look ahead, they will react prior to the Fed’s policy change becoming obvious.
Holger Berndt, CFA
Director of Research
[email protected]
