A runaway train is one which operates at unsafe speeds due to loss of operator control. The thought of such an event is likely to conjure images of panic for passengers and anyone in its path. Higher than expected inflation reports last week added to fears inflation is becoming runaway. Has the Federal Reserve lost control? Is inflation on a trajectory to become runaway? We won’t have definitive answers to these questions for a few months, but we can offer our thoughts and assessment.
The Consumer Price Index (CPI) increased by 9.1% over the past twelve months; the most since 1981. This reading was even hotter than the previous few months and above expectations, indicating that inflation is continuing to accelerate. The Producer Price Index (PPI) was higher by a whopping 11.3% compared to a year ago; much higher than the 10.7% consensus estimate. All inflation numbers seem to be suggesting that inflation is continuing to accelerate. Both CPI and PPI are reported with “headline” numbers as well as “core” where food and energy, which tend to experience greater price volatility, are removed. But it is food and energy, along with housing, that are causing the most pain for many Americans and leading to such soaring levels of inflation. In fact, the Federal Reserve last week even acknowledged the Core CPI and PPI should now be largely ignored since they are not reflective of what most Americans, and people all over the globe, are experiencing. Gas and food prices are now taking up the largest percentages of household budgets in a generation, if not longer.
It is no surprise the Fed is seemingly well behind the curve when the Federal Funds target rate is 1.75% and inflation is over 9%. Action taken thus far seems to be having a very muted impact on inflation. However, we do need to acknowledge if often takes many months for tighter monetary policy to have a discernible impact on the economy. It tends to take about 6 months to experience the full effects of an interest rate increase and the Fed only began to raise rates in March. But we now know the threats of inflation were largely ignored for too long and the Fed had a late start and are now trying to catch-up.
Stopping the Train
Stopping a runaway train can be very difficult, especially to do so in a manner where nobody is hurt. The same is true of inflation. At this point it seems the outcomes will be either inflation truly becomes runaway and causes structural damage to the economy from a long-term reduction in confidence or is contained by the Fed via higher interest rates, which also has the potential to cause damage since it would likely lead to a recession. There is a chance inflation will “fizzle” out on its own via increased supply, which would imply the supply chain issues we’ve experienced over the past couple of years are resolved, and/or reduced demand from lower spending. The Fed has very little, if any, control over supply but higher prices and higher costs of borrowing could reduce demand.
On the demand side, an increase in money supply is perhaps the largest driver of inflation. The Fed has begun a quantitative tightening (QT) program by selling bonds they held on their balance sheet, sucking money out of the economy. But they have much work to do to get enough money out of the system to have make a noticeable difference in reducing demand to help lower inflation.
Commodities prices have fallen rather dramatically over the past month, which was not reflected in the most recent reports. Housing costs, which are the largest component of CPI showed continued increases in the latest report, but there are now reports of listing prices of homes for sale are being dropped which is likely to lead to a moderation, if not some pullback, in housing prices and reduction in housing costs. A lot can happen over the next month but early indications are we could see a bit of a softening in the inflation reports next month. We want to stress this is merely a prediction on what the reports will reflect based recent price changes. It does not imply we think inflation is moderating; in fact we think it will remain elevated through at least the end of the year.
Odds of a 100 basis point, or 1%, interest rate hike by the Fed at their meeting next week have increased greatly. Previously it seemed to be a foregone conclusion they would raise by 75 basis points, or three-quarters of 1%, with the possibility of only a half-point hike. That changed after last week’s inflation reports and it looks like it will be either a 0.75% or 1.00% hike as the Fed tries to be more aggressive in their fight with inflation before it becomes out of control. But if the Fed does hike more aggressively, it also increases the chances of pushing us into a recession.
Earnings season kicked off last week with many of the major banks reporting. Earnings drive stock prices and historically we see the stock market move higher 75% of the time during an earnings season. However, expectations are now being lowered with less consumer activity, higher expenses, and headwinds from higher interest rates. The earnings already reported were largely disappointing, with local favorite UnitedHealth Group beating estimates and being a notable exception. Thus far we are not being given much reason for optimism. However, it is still very early in this earnings cycle and positive surprises could help bolster the stock market, leading to some upside momentum. Between earnings, the Fed, and the quarterly GDP report, there will be much to pay attention to for the remainder of July.
Be sure your portfolio is protected and you do not find yourself in an uncontrollable situation that threatens your lifestyle. A falling stock market and higher costs are leading to some trying times. We are here to help you feel secure in your retirement, so please give us a call if you would like help ensuring you have complete control over your long-term financial plan.
Have a wonderful week!
Nathan Zeller, CFA, CFP®
Chief Investment Strategist
Please contact us if you would like to review your individual financial plan or learn how the TaxSmart™ Retirement Program can help you.
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