As we make our way into 2023, likely with peak inflation behind us, it is important to look at where it will ultimately stabilize. Currently, inflation is decelerating and in the process of normalizing but we must ask what is the new normal? Will we make it back to the Federal Reserve’s target of 2%? Or are we now in a new era of structurally higher inflation? Demographics, De-carbonization, De-globalization, and Dominance of Fiscal Policy, the four D’s, lead me to believe getting back to the 2% target will be a difficult task. Let’s explore.
Demographics – The baby boomers, who have been shaping the economy for many decades, are finally hitting their retirement years. These are years in which as they stop working, their contribution to economic output vanishes while their consumption continues. This large aging cohort is leading to worker shortages. A lack of supply of workers leads to a supply/demand imbalance creating higher wages for those who do work thus keeping persistent upwards pressure on inflation.
De-carbonization – Our transition to a net zero carbon emissions world has become increasingly important for both politicians and investors. And while this is a high priority for many, through this transition both oil and gas are still needed to meet current and future energy demands. Fortunately and unfortunately, more focus, subsidies, and investments are being made into low/no carbon alternatives rather than traditional energy. This could result in shortages, driving up prices and potentially disrupting global economic activity.
De-globalization – Prior to Covid and War, companies and governments were both confident and comfortable in their global supply chains. They were efficient, cost-effective and believed to be resilient. These recent events have caused them to re-think their supply chains and action is now being taken to trade efficiency for resiliency in order to decrease the risk of future global disruptions. Building up bigger inventories, nearshoring / onshoring production, and finding alternative close-by suppliers are all being discussed and/or implemented to better manage new supply chain complexities. All these options likely lead to increased costs for companies which will ultimately be passed on to the end consumer of the good or service.
Dominance of Fiscal Policy Instead of Monetary Policy – After Covid arrived the Fed responded by bringing down the Fed Funds Rate to 0% in an attempt to keep the economy from falling apart. Not thinking this was enough, our government quickly resorted to Fiscal policy to stimulate the economy, passing nearly $9T in 2020/2021. While we could argue they did “too much”, one thing is clear, it worked to spark growth and it was well received by consumers and businesses. While our government acknowledges this fiscal stimulus may have played a small role in the resulting inflation, the response on both sides of the aisle was to pass additional Fiscal stimulus in 2022 (Inflation Reduction Act). Continued Fiscal policy seems inevitable as we move towards a more socialistic society where wealth inequality is exacerbated by even more inflation. Populism is on the rise with millennials, and politicians understand who will eventually be the largest cohort of voters. It is hard to ignore that both sides of the aisle continue to move towards fiscal expansionary policies ultimately leading to additional inflationary pressures.
Summary: While inflation is decelerating and in the process of normalizing, it is hard to imagine this will be an easy road back to the Fed’s 2% target. Most investors would prefer a pre-covid world with an accommodative Fed, stable inflation, and slow steady growth. Equities have proven to perform quite well in that environment but we have to be realistic with the inflation challenge that lies ahead. We will closely be following the impact of the above four D’s as this normalization process plays out.