We invited Jeffrey Korzenik, Chief Investment Strategist at Fifth Third Bank, to share some thoughts on post-pandemic economic recovery and his perspective on inflation. In the commentary below, Jeffrey does a nice job of explaining the different views as well as providing some long term considerations and conclusions. We hope you enjoy this analysis.
--Marc J. Sharpe
By: Jeffrey Korzenik, Chief Investment Strategist, Fifth Third Bank
Post Covid Outlook
What could go wrong?! The U.S. economy continues to reopen with ample room to continue growing since employment and industrial capacity remain well below pre-pandemic peaks. Unable to spend during the lockdowns and the recipient of government transfers, the American consumer has over $2 trillion in excess cash that should continue to support economic growth while the U.S. Federal Reserve maintains an unprecedented easy money, pro-growth policy. With global vaccination rates continuing to improve, even COVID-19 variants seem unlikely to upset the positive economic momentum.
In our experience, we worry most when everything looks great for investors. This doesn’t mean abandoning risk-oriented investments like stocks, but it does mean we must identify potential threats to the bull market.
The Misery of Inflation
Our primary concern is Inflation – the broad rise in the cost of goods and services with no corresponding increase in value. It’s no secret that inflation has been evident in recent months. Compared to year ago levels, the Consumer Price Index (CPI) for June was up 5.4%. Some, but not all, of the increases in inflation we have witnessed recently are related to the “base effect” – the comparison of prices today to year-ago levels when the pandemic initially sent prices lower. This bout of deflation was short lived, so that effect is passing. The real debate is not whether we’ve seen inflation over the past year, but whether it will persist into the future.
Readers of a certain age will remember that persistently high levels of inflation in the 1970s were associated with difficult economic times. Inflation, when added to the rate of unemployment, was famously summarized as the “Misery Index” by economist Arthur Okun. In the modern history of this measure, “misery” peaked in June of 1980 when the Consumer Price Index registered inflation for the preceding year at 14.3%.
Inflation produces misery in multiple ways. For consumers, it means that their hard-earned dollars do not purchase as many goods and services, so real consumption slows, or could even decline. For businesses, inflation creates new risks and challenges to profitability. For investors, inflation usually means poor bond portfolio performance and challenging times for stock investors. Stocks are often said to be “inflation hedges,” but this is typically only true over the long run – corporations may be able to build their earnings by increasing prices, but valuations of those earnings and the price of stocks may suffer for a period.
The Fed: Be Careful What You Wish For
This cycle, our particular worry over inflation is the impact it might have on the policies of the Federal Reserve Bank. Some definitions are in order. The Fed focuses on an inflation measure called the Personal Consumption Expenditure (PCE) deflator. It runs a little lower than the widely reported CPI measure since it accounts for consumers changing their behavior (e.g., if pork gets expensive, people buy more chicken instead). On a month-to-month basis, no matter the measure, economists tend to focus more on “core” inflation, which excludes volatile food and energy prices. Those particular prices do matter if they represent long-term trends, but can be so volatile over the short term that they distort the entire index.
Historically, central bank policy called for raising interest rates when PCE inflation exceeded 2% (to put the brakes on the economy) and lowered rates when the measure fell below 2% (to give the economy a boost). This target was considered a prudent pivot point for the Fed’s mandate of price stability. It was thought that inflation below 2% risked slipping into deflation, where prices would actually decrease and threaten economic growth through discouraging consumers and undermining loan collateral. Inflation over 2% was thought to risk an inflationary spiral as rising expectations for price increases could become a self-fulfilling prophecy.
Over the past decade, the Fed consistently fell short of meeting its 2% inflation target. This forced the central bank to keep rates artificially low – punishing savers – by growing its balance sheet through asset purchases (quantitative easing), which unsettled investors. In 2020 the Fed elected to try a new approach, operating under a “new monetary policy framework” that explicitly allows more room for inflation. Specifically, our central bankers committed to monetary stimulus until inflation stayed above 2% for an extended period and the economy supported “broad-based and inclusive” employment. While this may sound rather obscure, the new monetary policy framework is a radical shift from past policies. For a central bank that has had to balance its dual mandates of price stability and full employment, this represents a tipping of the scales toward employment. In addition to a staggering amount of fiscal stimulus, this monetary stimulus stokes fears of inflation caused by “too many dollars chasing too few goods.”
The Fed’s new approach has no precedent, so the question remains whether this is a prudent policy shift or one that will unleash destructive inflationary forces.
The Transitory Case
Federal Reserve leadership, including Fed Chairman Jerome Powell, has observed the recent rise in inflation and declared it to be “transitory.” The Fed does not mean that the recent rise in prices will reverse, but rather that the rate of increase in prices will return to levels that are more in line with inflation that the central bank considers acceptable. While these levels have never been fully articulated, the Fed’s willingness to accept inflation over 2% for an “extended period” probably means in the 2-3% range for that period.
There are three key factors that support the argument that the recent spike in prices will indeed prove transitory:
- “The cure for high commodity prices is high commodity prices,” is a saying that reflects the historical tendency of an increase in prices to produce new supply that subsequently moderates prices. The Fed and others have already pointed to the lumber market where a doubling of prices this spring has reversed to levels last seen in January, prior to the price spike. Outside the commodity market, logjams in shipping, semiconductors, and many finished goods are likely to be resolved as supply chains and inventories adjust. In other words, if inflation is “too many dollars chasing too few goods,” we likely won’t have “too few goods” over time.
- Historically, inflation is not sustainable when there is slack in the economy – i.e., underutilized resources. Notably, examining two widely used measures, industry is still operating well below capacity and the labor force participation is well below pre-pandemic levels.
- The Fed emphasizes the role of inflation expectations, noting that inflation expectations remain very low. Consumers push back on price increases when they don’t expect prices to keep going up.
We are largely in agreement with the “transitory” inflation view. However, we note a few caveats that suggest that the Fed is underestimating the durability of the forces that have been unleashed. We should also recognize that our central bankers’ projections have so far underestimated inflation, calling into question some of their assumptions and calculations.
Looking at the three pillars (above) of the transitory argument, we would offer cautions:
- Commodity Prices
It is true that high prices bring out new supply but that assumes that there are no barriers to the investment required. Regulatory uncertainty in the energy industry may be an example of the sort of barrier to new production that keeps pricing on an uptrend. Even without such policy-related issues, the pandemic has rapidly shifted patterns of working, living, transportation and spending in ways that create logjams that don’t get resolved quickly (e.g., demand for houses in suburban “zoom-towns” that have attracted former urban dwellers).
While we are particularly hopeful that corporate America can attract workers off the sidelines, a demographic analysis suggested that there may be fewer workers readily available than the Fed believes. Millennials are coming of an age when some will choose to leave the workforce to raise children while the Baby Boomers continue to retire. We project long-term tight labor markets that will put upward pressure on wages. Unless offset with productivity gains, higher compensation costs are a key ingredient in driving inflation.
Fed Chair Powell routinely refers to inflation expectations as being well “anchored.” We are partial to this nautical analogy. Anchors are very powerful at holding ships in place unless they come loose, which then puts a boat at the mercy of the wind and current. So, yes, inflation expectations remain low, but we believe that could change faster than Fed policy could adapt.
We have observed a multi-decade period of low inflation driven by globalization, rapid technological adoption, and the aging of the world’s population. These forces are still in place, but arguably with less impact than during the preceding years. The cost reductions once associated with sending manufacturing to China have largely dissipated, and while other “cheap labor” countries exist, the pricing advantage and capacity is nowhere near what China offered at the beginning of the century. The aging of the world’s population continues – a disinflationary force related to associated modest consumption growth – but in the U.S. that may be offset by the large Millennial generation starting to come into high spending years. We do expect that the rate of technological innovation and adoption will remain high, suggesting that this will continue to be a disinflationary global force.
Conclusion and Implications
Our belief is that inflation will moderate from the recent spike but may surprise the Fed by staying modestly higher for longer. In other words, inflation is “transitory-ish.” With long-term disinflationary forces still intact, we cannot make the case for runaway inflation. In fact, we are quite optimistic about the business community’s ability to adapt to the challenges of the post-pandemic economy including labor force challenges.
For investors, this is ultimately a constructive view. A little more, but not a lot more, inflation would restore credibility in the Federal Reserve’s stewardship of monetary policy and help arrest fears that the central bank will never be able to go back to a “normal” monetary policy (non-zero interest rates, for example). The Fed’s projections may underestimate inflation, but in our view not to the degree that would undermine their policy approach, but rather offer the central bank a path to gradually return to normalcy. The persistence of easy money has had a cost. Small speculative bubbles have diverted capital, unproductive companies have stayed afloat to the detriment of better-managed firm growth, and savers have been clearly excluded from income opportunities.
Slightly higher inflation, should it persist as we believe, means that bonds yields today offer limited value. Stock investors should be prepared for headlines that call into question the Fed’s new monetary policy framework, but we have always observed that “equity markets climb a wall of worry.”
Jeff Korzenik is Chief Investment Strategist for Fifth Third Bank, where he is responsible for the Bank’s overall client investment strategy. For more than 30 years, Jeff has been a thought leader in the investment industry. A regular guest on CNBC’s Squawk Box and Bloomberg, Jeff’s writings on economics and public policy have been published in Barron’s, Forbes, The Chicago Tribune and other periodicals. Jeff earned both a Bachelor of Arts degree in Economics and a Certificate of Proficiency in Near Eastern Studies from Princeton University.
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