Whistling past the inflation graveyard
Prices might be stickier than the Fed thinks.
Inflation has surged in recent months due to sharp increases in commodity and labor costs, and many companies have passed those on to end customers in the form of higher prices. The Federal Reserve maintains the elevated levels are expected because of the unwinding of procedural base effects as the U.S. economy extricates itself from the pandemic’s deep recession. Further, policymakers view the price spikes as transitory, attributable to what they say will prove a temporary surge in demand, as well as supply-chain bottlenecks and an elevated savings rate.
Investors, on the other hand, have become increasingly concerned over the past five weeks that the price growth may be stickier than the Fed believes and that it could hurt financial markets. To be sure, we’re still several months away from answering this question. But if the Fed eventually decides inflation is running hotter than expected, will they shift their interest rate and asset purchase (quantitative easing) plans in a timely fashion? Or will they stick to their well-established game plan to keep uber-accommodative monetary policy unchanged through calendar 2023? If the inflation genie is out of the bottle now, will its multiyear head start force the Fed into a more draconian, Volker-esque response down the road?
What is a procedural base effect? It is Fed-speak. To translate: as we’re calculating year-over-year (y/y) inflation, we’re dropping off low or negative inflation readings from the economic trough of the global pandemic a year ago (from roughly February through May). At the same time, we’re replacing those figures with the more robust current readings brought on by the powerful V-bottom recovery. So both the Fed and most investors anticipated inflation would surge this spring. The open question is whether it will peak and recede after, as the Fed believes, or continue into the second half of 2021 and beyond—the market’s growing worry.
Nominal commodity prices sharply higher over the past year:
- Lumber With the housing market at a 14-year high, lumber prices have recently surged nearly seven-fold, from $251 (per 110,000 board feet) in April 2020 to a recent peak of $1,711 in mid-May. Although the housing market is thought to be undersupplied by about four million units (about four years of annual production), lumber mills are unenthusiastic about building more productive capacity, lest they mistime the peak of the cycle.
- Copper With housing and manufacturing going strong, copper has soared 135% from $208 (per 25,000 pounds) in March 2020 to $489 earlier this month.
- Crude oil (West Texas Intermediate, or WTI) Crude doubled in price from $34 (per 42-gallon barrel) last November to $68 earlier this month. At the peak of the crisis last April, WTI temporarily traded at a negative $40 per barrel. Due to a lack of storage capacity and a collapse in demand a year ago, oil producers were willing to give buyers $40 to take each unwanted barrel off their hands. But today, with the auto industry’s inexorable shift toward electric vehicles, President Biden’s ban on fracking on federal land and his cancelation of the Keystone XL Pipeline, oil companies are not drilling for new sources of oil, putting upward pressure on prices in the wake of a surge in demand, as the economy and travel normalize.
- Unleaded gasoline This lagging indicator has soared 72% from $1.77 per gallon nationally in April 2020 to $3.05 this month. With the summer driving season starting next week with Memorial Day weekend amid a jailbreak economy due to vaccinations, prices could easily surge to $3.50 per gallon this summer.
- Steel With the rebound in manufacturing and construction, prices have nearly quadrupled, from $507 per ton in March 2020 to $1,956 this month.
- Agricultural commodities Due to a surge in global demand (particularly in China) and poor growing conditions in Latin America, prices have risen sharply for the three most important agricultural commodities grown in the U.S.
- Corn From $3.46 per bushel last August, prices soared by more than 110% to $7.35 earlier this month.
- Soybeans From $8.30 per bushel in April 2020, prices doubled to $16.70 earlier this month.
- Wheat From $4.95 per bushel last June, wheat rose by 55% to $7.70 earlier this month.
Wages rising sharply Average hourly earnings rose at an outsized annual pace of 8.4% in April’s disappointing nonfarm payroll report, despite March’s record JOLTS, a 14-month cycle low in initial weekly jobless claims and a 7-month high in April’s ADP private payroll survey. The problem appears to be Biden’s $1.9 trillion stimulus program from March, which extended an unemployment bonus of $300 per week into September. That’s in addition to average weekly unemployment benefits from the states that average $318 per week (within a range of $275-387). That $618 average weekly unemployment benefit in a 40-hour work week translates to $15.50 per hour.
For lower-wage workers concerned about contracting Covid-19 and who have child care or public school issues with their kids in states where those facilities are not yet opened, it made financial sense to remain home collecting unemployment, rather than returning to their now-open jobs. Consequently, companies find themselves bidding against these generous unemployment benefits to entice their employees to come back. As a result, 20 states have already announced they are scaling back the $300 unemployment bonus this month or next.
Core inflation rising, a trend that is likely to continue for the next several months.
- Core Producer Price Index (PPI) Peaked at 1.6% y/y in January 2020 pre-pandemic, wholesale inflation troughed at -0.20% in May 2020, and has since surged to a record high of 4.6% in April 2021.
- Core Consumer Price Index (CPI) Peaked at 2.4% y/y in February 2020, retail inflation troughed at 1.2% in June 2020, and has since soared to 3% in April 2021, a 26-year high.
- Core Personal Consumption Expenditure (PCE) index Peaked at 1.9% y/y in February 2020, it bottomed at 0.9% in April 2020, and it has rebounded to 1.8% in March 2021. April’s reading will be reported next week, with a consensus of 3%, which would be a 29-year high.
No Carter-like stagflation But due to technology and globalization, we don’t expect these inflation metrics to approach or exceed the double-digit levels through which we suffered under President Jimmy Carter from 1976 through 1980.
What’s the Fed to do? Fed Chair Jerome Powell has pledged to allow core PCE inflation to average 2% for at least a year before he begins to raise the fed funds rate, and we could be starting the clock on that pledge as early as next Friday’s core PCE report. Over the past quarter-century, it has average only 1.7%, within a range of 2.5% to 0.9%. In addition, the Fed is making terrific progress in achieving its objective of boosting employment for low-wage workers. Pre-pandemic unemployment for those over 25 years of age with less than a high school diploma was only 5.8% in February 2020. It soared to a cycle peak of 21.2% in April 2020, but it has since plunged to 8.2% in March 2021.
The next Fed touchstones are the new Summary of Economic Projections from their upcoming Federal Open Market Committee (FOMC) meeting on June 15-16, and Chair Powell’s keynote address at the Fed’s annual symposium in Jackson Hole, Wy., in late August.
Take away one ‘thinking?’ A sentence in the Fed’s minutes from their most recent FOMC meeting on April 27-28 (released this past Wednesday) demonstrated that perhaps the recent spike in inflation has caught their attention:
“A number of participants suggested that if the economy continued to make rapid progress toward the Committee’s goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases."