Revisionist history

Bottom Line

Nominal retail inflation has soared from 1.4% year-over-year in January 2021, when President Biden took office, to a 40-year high of 8.5% in March 2022. We fully expect CPI inflation will rise to 9-10% before peaking in coming months. Russia’s invasion of Ukraine on Feb. 24, and the resultant spike in crude oil prices (WTI) from $90 to $130 per barrel, still is working its way through the economy.

Moreover, wholesale Producer Price Index inflation has soared from 1.6% in January 2021 to a record high of 11.2% in March 2022, and the core Personal Consumption Expenditure (PCE) index—the Fed’s preferred measure of inflation—has risen from 1.5% in January 2021 to a 39-year high of 5.4% in February 2022. We expect core PCE to rise to 6% in coming months before peaking, a level triple the Federal Reserve’s 2% target. 

Cause & effect What fueled the worst inflation in the U.S. since the Jimmy Carter/Paul Volker era? In short, too much money chasing too few goods, created through the confluence of several Washington policy developments. First, supply-chain disruptions started by the Covid pandemic were exacerbated by government policies. Next, while the initial implementation of the Federal Reserve’s aggressive monetary policy was completely appropriate, it remained overly accommodative for far too long. Finally, while generous fiscal policies helped to extricate the economy from the pandemic recession in its early stages, the continuation of those policies was akin to throwing kerosene on a bonfire. 

Fed well behind the curve The Fed ended its zero interest-rate policy by raising the target range of its fed funds rate by a quarter point at its March 2022 policy-setting meeting for the first time since 2018. We expect the Fed to aggressively shift to half-point increases (for the first time in 22 years) at each of the next three meetings (May 4, June 15 and July 27). We anticipate three more quarter-point hikes through year-end and four more over the course of 2023. That would take the lower band of the fed funds rate up to 2.5% by the end of this year and to 3.5% by the end of 2023. 

At the same time, the Fed ended its $120 billion monthly bond-buying program last month and will soon begin to shrink its bloated $9 trillion balance sheet by one-third over the next three years, with a monthly cap of about $95 billion ($60 billion in Treasuries and $35 billion in mortgage-backed securities), which equates to an additional effective tightening of about 25 basis points annually. 

Inflation not temporary Because of the sustainable surge we saw in wages, food, housing and energy costs, we’ve been forecasting for a year now that inflation was much stickier than the Fed was willing to admit. Because they argued up until last December that the spike in inflation was transitory, they’ve got to work assiduously over the next two years to stuff the dreaded inflation genie back into the bottle without damaging the economy. It won’t be easy and investors are becoming increasingly concerned the Fed won’t stick a soft landing. Benchmark 10-year Treasury yields soared from 1.5% at the end of last year to a 3-year high at 2.97% today. After an 11% rally in late March, the S&P 500 has corrected by more than 7% over the past three weeks, a sell-off that we expect will accelerate in coming weeks and months. 

CEA punts The Council of Economic Advisers (CEA) published its annual economic report of the president last week, and its Chair Cecilia Rouse placed the blame for the surge in inflation squarely on the Russian invasion of Ukraine and the subsequent volatility in the energy market. 

But Dr. Douglas Holtz-Eakin, the retired director of the Congressional Budget Office (CBO) under President George W. Bush, concluded in a policy note today that President Biden’s fiscal policies account for 93% of the inflation in the U.S. economy over the past 15 months, compared with only 7% due to the rise in energy prices since the start of the Russian invasion. 

CARES Act much needed On the fiscal policy side of the equation, we had no problem with the $2.2 trillion Coronavirus Aid, Relief & Economic Security (CARES) Act, which was signed into law in March 2020 and provided desperately needed support for the economy. But the subsequent $900 billion Consolidated Appropriations Act, signed into law in December 2020, was unnecessary, as the economy was already out of recession and had rebounded strongly. 

ARP not so much Worse than unnecessary was the $1.9 trillion American Rescue Plan (ARP), which was signed into law in March 2021 and was inflationary. Chair Rouse argues that the sustainability of the economic recovery was unknown at that time. We disagree on three levels.

• First, we had been forecasting that the pandemic recession, which started in February 2020, would end by May or June 2020. The National Bureau of Economic Research (NBER) in July 2021 declared the end of the recession, dating its conclusion in April 2020. This marked the shortest (at two months) but deepest recession in history.
• Second, we enjoyed a powerful V-bottom economic recovery in the middle of 2020. Gross domestic product in the second quarter of 2020 plunged 31.2% (quarter-on-quarter, annualized), marking the worst quarter in U.S. economic history. But it rebounded 33.8% in the third quarter of 2020, the single best quarter in history. 
• Third, we had been forecasting that the GDP output gap, created by the pandemic recession, would be fully closed by the second quarter of 2021. GDP (on a chained-dollar basis) peaked at $19.25 trillion in the fourth quarter of 2019, plunged to a trough of $17.26 trillion in the second quarter of 2020 and rebounded to $19.37 trillion in the second quarter of 2021. GDP has risen to $19.81 trillion in the fourth quarter of 2021. 

This could get ugly As we enter a seasonally choppy period historically, we continue to advise that investors hunker down and play defense. We prefer stocks over bonds, with an overweight in relatively cheaper, less risky value stocks that enjoy higher dividend yields.

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