Inflation is one of the biggest conversations happening on the street right now so let’s dive in to get the current state of affairs. Questions we want to address:
- What is the cause?
- What does the Federal Reserve mean by inflation being transitory?
- What can they do if it does not prove to be transitory?
- How does it impact markets?
What is the cause?
First, let’s identify what is driving the inflation we have seen over the past year. We’ve re-opened the economy with an unquenchable urge to spend alongside massive supply chain disruptions and a tight labor market. Looking back now, this was not an ideal situation to find ourselves in. Both consumers and businesses were flush with cash (provided by government handouts through transfer payments / PPP loans) and this created a significant amount of demand for goods, services and labor. This demand has far outweighed the supply we could bring back online after shutting down the economy. As you can guess, in this unique situation, we’re bound to see prices rise sharply, and they did just that.
What does the Fed mean by inflation being transitory?
I think we can all agree we have seen inflation in our daily lives and it has stuck around longer than many expected, including the Federal Reserve (Fed). They have been catching a lot of heat lately as they still hold the position that inflation is likely to prove transitory. What do they mean by this? When the Fed says transitory they mean the pace at which the price level is rising today is unlikely to sustain for a long time. So let’s think in prices. The Fed expects prices to rise next year, just not at the same pace at which it has increased over the past few quarters. This is still their base case but they are watching the data closely to see if they will be proven wrong (in some people’s minds they already have).
What can they do if it is not transitory?
The Fed believes accumulated household savings, transfer payments from the government and supply chain disruptions are likely to only last a few more months. They have identified these outliers which they believe to be the cause for the higher than expected inflation we are seeing. But what if they are wrong? What if the increase in housing and shelter (which account for nearly 25% of the CPI measurement) proves to be sticky and keeps inflation higher for longer? Well, it would mean they would have to start tightening financial conditions. First by slowing (or ending) asset purchases and then if necessary they would raise interest rates.
How will it impact markets?
Currently, the market is anticipating the Fed to announce they will begin tapering asset purchases by the end of the year and finish by the middle of next year. In addition, the Fed has led the market to believe the first interest rate hike will occur by the end of 2022 and they will raise rates an additional three times in both 2023 and 2024. If the Fed changes either one of these timelines to be sooner than, or at a faster pace than anticipated we will likely see a negative reaction in equity markets. If the Fed is right and inflation does in fact prove to be transitory they will have more flexibility to keep the economy running hot while focusing on meeting their mandate of maximum employment and ensuring price stability. This will likely lead equity markets higher as financial conditions would stay accommodative for longer.