Pig in the python
Unchecked inflation could put the squeeze on the economy.
Nominal commodity prices have gone vertical over the past six to 12 months, as the U.S. economy has experienced a powerful V-bottom resurgence since the recession ended last May or June. But core inflation (which strips out food and energy) has remained relatively benign. It’s recovering from its cyclical trough last year, but it’s certainly not following the pace of the nominal spike we’ve seen from the commodity super cycle.
The bond vigilantes, however, have nearly doubled benchmark 10-year Treasury yields over the past three months (from 0.90% at the end of last year to 1.75% two weeks ago), as they’ve begun to sniff out the risk of rising core inflation against the backdrop of strong economic growth. Given President Biden’s extraordinarily aggressive fiscal policy plans and the Federal Reserve’s ongoing pledge to keep the fed funds rate zero bound through at least the end of calendar 2023, it’s likely that eventually something’s gotta give.
In our view, none of this can derail the strong economic and stock market recovery that’s already baked in the cake for this year. We continue to forecast 6.8% GDP growth in 2021 and a 20% rally in the S&P 500 to 4,500 by year-end. But if growing inflationary pressures are left unchecked by the Fed, fueled by poor fiscal policy decisions in Washington, then we could begin to negatively impact economic and corporate profit growth and share-price performance perhaps during calendar 2023.
Commodity super cycle Several of the key commodities we monitor have soared over the past year as the domestic economy, which bottomed in April 2020, has recovered sharply:
- Lumber With the housing market at a white-hot 14-year high, lumber prices quadrupled from $251 last April (per 110,000 board feet) to a recent peak of $1,045 in mid-March.
- Copper With manufacturing and housing strong, copper doubled from $213 last March (per 25,000 pounds) to $438 last month.
- Crude oil (WTI) Oil doubled in price (per 42-gallon barrel) from $34 last November to $68 earlier this month. At the peak of the crisis last April, WTI temporarily traded at a negative $40, due to a lack of storage capacity and a collapse in demand. Oil producers were giving buyers $40 to take each unwanted barrel off their hands.
- Agricultural commodities Due to a global surge in demand and poor growing conditions in Latin America, prices have risen sharply for America’s three most important agricultural commodities:
- Corn soared from $3.40 per bushel last August to $5.72 last month (almost 70% jump).
- Soybeans rocked from $8.25 per bushel last April to $14.60 earlier this month (77% increase).
- Wheat jumped from $4.95 per bushel last June to $6.90 last month (nearly 40%).
Core inflation lagging While core inflation has also risen over the past year, the pace of increase is lagging this nominal spike:
- Core consumer price index (CPI) peaked at 2.4% year-over-year (y/y) in February 2020 before the pandemic, it troughed at 1.2% in June 2020, but it has inched up to only 1.3% in February 2021.
- Core personal consumption expenditure index (PCE) Peaked at 1.9% y/y in February 2020, bottomed at 0.9% in April 2020 and it has rebounded to 1.4% in February 2021.
Core CPI usually leads core PCE (the Fed’s preferred measure of inflation) by 0.5%, so the current spread between them is unusual. With core CPI lagging core PCE by a tick at present, they’re now 0.6% out of whack.
However, we expect that core inflation will start to move higher over the next few months, as the sharp decline in prices we experienced during March, April and May 2020 at the height of the pandemic begin to roll off. In fact, our research friends from RDQ Economics point out that the month over month increase in core PCE inflation over the last three months annualizes to 2.5%—well above the current 1.4% pace.
But due to long-standing pressures from technology and globalization, we don’t expect core PCE to run quite that hot this year or next. In fact, Fed Chair Powell refers to this impending increase in core inflation as “procedural,” as last year’s low readings are excluded from the y/y data.
Throwing another fiscal policy log on the fire Despite the strength in the economy, based upon what the Fed, Congress and the Trump administration collectively orchestrated last year, Biden’s recent $1.9 trillion fiscal stimulus plan was roughly triple the size of the current $600 billion GDP output gap in the U.S. economy, which we expect will be closed organically by midyear. Moreover, Biden and Congress are now crafting plans for an additional $2-4 trillion of fiscal stimulus later this year.
But Larry Summers, who was President Clinton’s Treasury Secretary and the Chair of President Obama’s National Economic Council, fears that too much government spending at this point in the economic cycle could overheat the economy and spark much higher inflation. Further, Summers believes that there’s a one-third chance that this could push the economy toward recession later in the cycle.
Total debt to GDP rising So we’re now at $29 trillion in federal debt—which may expand to $33 trillion later this year—which could eventually approximate an outsized 165% total debt-to-GDP ratio. With market interest rates rising, that could make it harder for Treasury Secretary Janet Yellen and Powell to service the debt.
But Powell has pledged to allow core PCE inflation to average 2% for “some time” before he begins to raise the fed funds rate. That means it could temporarily reach 2.25% to 2.50% for perhaps a year or longer before the Fed comes off the sidelines. Over the past quarter-century, core PCE has average only 1.7%, within a range of 2.5% to 0.9%.
Powell has explained that the Fed’s objective is to boost employment, particularly for low-wage employees, by keeping interest rates lower for longer, to allow the economy to run hotter for longer. But the risk is an unintended monetary policy error if the Fed finds itself behind the curve. This may be exacerbated by the potential for sharply higher taxes on corporations and individuals to fund these spending initiatives, which could slow both economic growth and the labor market recovery over the next few years.