Inflation Nation?

Investors received encouraging news related to global supply chains with several of the largest automotive manufacturers suggesting that their production levels may be returning to normal soon. This may be a sign that the worst of the semiconductor chip shortage may be behind us.

New York state manufacturing expanded by more-than-expected in November. The Federal Reserve Bank of New York’s general business conditions index rose to 30.9 from 19.8 a month earlier. A reading above zero indicates sector expansion. The prices paid component jumped 7.3 points to 50.8 – signaling that rising input costs have yet to level off. While a regional survey, these regional surveys feed into the national Institute for Supply Management’s national manufacturing index. Later this week the Philadelphia Fed and Chicago Fed will also report their findings, which should give investors insight into what national metric will look like.

The University of Michigan’s consumer sentiment gauge slipped from 71.7 in October to 66.8 in November. Sentiment has been sliding steadily since April 2021, which is when consumer prices started to rise. Consumers also reported a belief that no effective policies have been developed to reduce the damage from inflation.

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Inflation is the hot topic among investors right now with the U.S. consumer price index jumping to 6.2% last week – its highest level in 31 years (see figure 1). However, the key question is if the U.S. is destined to become an “inflation nation” or is inflationary indeed transitory? Thus far, the sharpest jump in prices has come from the energy sector with gasoline prices up almost 50% year-on-year and broader energy prices up about 30% year-on-year. Excluding energy prices, the consumer price index is up 4.7%. This reflects the strong gains in oil prices with West Texas intermediate prices climbing from $39.40 in October 2020 to $81.48 in October 2021. However, this pace of gains is highly unlikely to repeat in 2022. Even if oil prices merely stabilize, the energy component will likely reduce consumer price inflation by a full percentage point next year.

This line chart shows the U.S. consumer price index vs. periods of U.S. recession from 1960 to 2021 year-to-date. Inflation could threaten the economic outlook if the Fed reacts aggressively, but that is not our base case.

That said, price gains are not isolated to the energy sector. Used car and truck prices are up 26% year-on-year, new vehicle prices are up almost 10% year-on-year, tobacco products are up about 9% year-on-year, and meat, poultry, and egg prices are up 12% (see figure 2). Even if we exclude the large price gains in food, shelter, energy, and used cars, the pace of inflation is currently running at a rate of 4.0%, which is well above the Fed’s average inflation target of 2.0% (though it should be noted that the Fed’s preferred measure of inflation is the personal consumption expenditure deflator which tends to run a bit lower than the consumer price index). And yet, the 10-year U.S. Treasury yield is just 1.61%, which is 30 basis points below where the 10-year U.S. Treasury yield finished 2019 (at 1.91%). This yield seems to be unusually low given that the inflation rate has more than doubled since then.

This bar chart shows the year-on-year percentage change for selected U.S consumer prices. Data shown indicates Gasoline up 49.6%, Used Cars and Trucks up 26.4%, Meals, Poultry, Fish & Eggs up 11.9%, Fuels and Utilities up 10.4%, New vehicles up 9.8%, Cigarettes up 9.1%, All Items up 6.2%, Food up 5.3%, Apparel up 4.3%, Pets, Pet Products and Services up 3.8%, Shelter up 3.5%, College Tuition and Fees up 1.8%, Personal Care Products up 0.2%, Prescription Drugs down -0.7%, Airline Fare down -4.6%, Health Insurance down -6.4%.

There may be a few reasons for this: 1) the bond market may think that inflation will indeed fade next year, 2) it believes that the Fed is going to hike rates to react to inflation which will lead to slower growth, or 3) even lower yields overseas are keeping U.S. rates anchored. One thing that is certain is that overall bond market volatility has spiked lately with investors seeing big moves in the short-end of the curve and in intermediate-duration Treasuries with rates jumping on expectations that the Fed may need to start hiking rates by mid-2022. As it stands now, the forward curve structure is pricing in an estimated 1.6 rate hikes by September 2022. Meaning that the market thinks that the odds of two rate hikes by September are higher than the odds of just one.

Is the Fed “Behind the Curve?”

The Federal Reserve has emphasized that the bar for rate liftoff is much higher than for the tapering of bond purchases. This has left some investors wondering if the Fed is “behind the curve” and if it will be forced to hike interest rates before it is currently telegraphing. We would argue that the Fed is often “behind the curve” on purpose. While the financial markets are often forward-looking and leading indicators, the Fed’s job is to accomplish the two mandates (often referred to as the dual mandate) that it has been assigned by Congress, which is full employment and price stability with an average inflation target of about 2.0%. Clearly, price stability is far from being resolved, but so is full employment with the labor force still 4.7 million people lower than it was in February 2020 (see figure 3). Assuming the U.S. economy continues to add back jobs at the current 2021 monthly pace of 581,000 jobs, then the labor market should be near pre-pandemic employment levels by right around June 2022, which is conveniently when the Fed’s bond purchase program is slated to end.

This line chart shows the U.S. Jobs Deficit Since February 2020. After a steep drop in March and April 2020, there has been a steady return to job positions filled. As of November 2021, there is still a deficit of 4.7 million jobs from February 2020.

Given that the economy appears to be on track for full employment and inflation is clearly running above target, it seems natural for the market to assume that the Fed may decide to hike interest rates earlier than currently projected. However, even if the Fed agrees with the market’s assessment, we doubt the Fed will want to signal this prematurely because it could tighten financial conditions before they have achieved their goal of full employment. It is our view, that they are currently “behind the curve” on purpose, but that may not always be the case with the Fed able to change the policy prescription whenever they would like. For example, the Fed only ordered the current pace of bond reductions to last through November and December, but it could easily accelerate that pace if it wants more flexibility to raise rates come mid-2022. Essentially, the Fed is “behind the curve” until it is not. Thus far, a repeat of the bond market’s 2013 taper tantrum seems to have been avoided, but there is always a risk that an unexpected Fed move in 2022 to “catch up with the curve” could create unexpected market volatility.

Freight Expectations

The Fed’s path forward will at least be partially dependent on the potential easing of supply chain bottlenecks. We think that the first quarter of 2021 will likely be telling as the holiday retail surge starts to fade. Importantly, there are very tentative signs that supply chain bottlenecks may be starting to ease a touch with the shipping rate for sending a container from Shanghai to Los Angeles having come down from about $12,400 for a 40-foot box container in mid-September to about $10,000 currently. This is still an elevated level, but it is trending in the right direction. The Baltic Dry Index, which measures the costs to ship raw materials, shows a similar trend (see figures 4-5).

This line chart shows the cost to ship a 40 foot container from Shanghai to Los Angeles from 2012 to 2021 year-to-date. There's been a dramatic increase in cost since February 2020.

This line chart shows the Baltic Exchange Dry Index which is a proxy for dry bulk shipping from 2020 to 2021 year-to-date.

None of this means that inflation is going to suddenly plunge once supply bottlenecks clear because there is still strong demand for goods and services and perhaps more importantly, shelter prices, are domestically driven and are likely to stay elevated for some time (see figure 6). However, we are hopeful that headline inflation may start to moderate by maybe February or March.

This line chart shows the Case-Shiller national home price index versus the consumer price index owner's equivalent rent of primary residence, year over year percent change from 2000 to 2021 year-to-date. The rise in shelter costs is unlikely to abate in the year ahead..

It is Infrastructure Week…Again

It is once again Infrastructure Week with President Biden signing the $1 trillion Infrastructure Investment and Jobs Act into law on November 15, 2021. While this marks an important milestone for Biden’s domestic agenda, the larger Build Back Better social investment bill remains in flux with progressive Democrats demanding to see the Congressional Budget Office’s scoring of the bill. For those unfamiliar, “scoring” is the method used to estimate how much a program might cost or how much revenue it might raise. It also estimates the bill’s potential long-run impact on economic growth, inflation, and deficits. The timing of the scoring is not clear at this point with the Congressional Budget Office telling Congress that it is going to take some time due to the size of the bill and that they may need to release the scoring in separate pieces. It’s also not clear if a partial scoring of the bill will be enough to secure a vote from progressive Democrats or if they prefer to wait for the entire scoring.

While we continue to expect the Build Back Better Act to pass eventually, rising inflation has likely complicated matters and lowered the odds of its passage some. Senator Joe Manchin’s (D-WV) comments provide an excellent example of the difficult sell that the Biden Administration faces with the Senator saying that, “It costs more than a dollar to shop at the local dollar store. That’s hard for West Virginians, a lot of people do shop there, it’s all they have. We have to take all this into consideration.” Importantly, unlike the bi-partisan infrastructure bill that garnered the support of 13 Republicans, the support of every single Democratic Senator with likely be needed to pass the Build Back Better Act. That remains a heavy lift.  

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