Thoughts on Inflation
Central banks around the world were presented with two core choices when the COVID-19 pandemic hit in March 2020. They could opt to do nothing and risk an ensuing wave of bankruptcies and unemployment, throwing the economy and society into a painful downward spiral, or they could expand their balance sheets by printing money to offset the pandemic-induced blow to business activity and employment.
Since February 2020, the Federal Reserve has doubled the size of its balance sheet from just over $4 trillion to $8.65 trillion1. Fed Chairman Jerome Powell championed this policy to offset an anticipated contraction in the U.S. economy of $4 trillion from bankruptcies, foreclosures, layoffs, cuts to lending, and other shocks to the supply of—and demand for—labor and goods. Considering that the overall size of the U.S. economy has since surpassed its pre-COVID-19 levels, it would appear that Powell and his team of analysts made the right decision. However, the Fed doubling its balance sheet comes at a price: higher inflation. The headline consumer price index (CPI) annualized inflation rate through November 2021 was 6.8%.2
Factors driving inflation
Multiple factors are driving inflation. Pent-up demand from consumers is driving retail sales, defying the expectations of many economists and analysts. Mastercard is forecasting a 7.4% increase in sales over the traditional U.S. holiday period from November 1 to December 24, excluding automotive and gas. This, coupled with the ongoing impact of the pandemic in many countries, is creating supply chain bottlenecks that are also contributing to higher prices.
Climate change initiatives and other regulatory changes are also expected to bring higher prices, at least initially. Pressure to raise the minimum wage, particularly for those in service industries, will likely reverberate up the pay scale, driving wage inflation, especially as unemployment is falling. Supply chain uncertainty may lead companies and jobs previously located in low-cost economies back to the U.S., which could increase costs for all, unless this onshoring is characterized by high levels of automation and artificial intelligence.
While the Fed’s doubling of its balance sheet is also a factor driving inflation, we view the assumption that it will lead to a similar rise in prices in the coming years as overly simplistic. Inflation is not only a function of the amount of money created by a central bank, but the velocity at which that money circulates through the broader economy. As Figure I shows, velocity, which has been declining for two decades, collapsed in the wake of COVID-19. This was partly due to a spike in personal savings (see Figure II) as Americans individually and collectively responded to the risk and uncertainly posed by COVID-19 by judiciously increasing their savings.
Inflation will settle—but to where?
After years of ~2% inflation, figures over 5% are understandably unsettling. Powell has indicated that "inflation is no longer transitory and the factors pushing inflation upward will linger well into next year."
While the trajectory for inflation is unclear, we do not foresee a return to the 1970s when inflation reached over 13%, interest rates hit 20%, the dollar plunged 95% against gold, and productivity collapsed. Materially different underlying economic factors were at play then. Whereas the 1970s were buffeted by two oil shocks and the transition to floating foreign exchange rates, America has since become a net energy exporter and businesses have long since adjusted to floating exchange rates.
During 2022, we anticipate that supply chain bottlenecks will lessen, along with the incidence of dramatic and notable price spikes that we have recently observed, such as in airfares. However, in viewing the ‘Fred Sticky Price CPI’ (Figure III), which omits two of the most volatile components of the CPI—food and energy—inflation has remained fairly constant over the past decade at around 2.5% (though it is at 3% today).
Barring an exogenous shock or policy mishap, we could see a period where inflation exceeds the 2% level to which the capital markets grew accustomed prior to COVID-19. Most of the businesses we analyze are managing their way through the labor shortages and supply chain challenges by raising wages, increasing prices, reengineering supply chains, and redesigning products—measures that tend to improve their ability to anticipate and meet increased demand. While these steps help mitigate supply shortages, they come with the price tag of higher inflation.
The Fed's role in price stability may bring risks
Some threats may lie ahead. We believe the Fed will act decisively if higher inflation lingers too long and that it understands that a failure to quickly address sustained high levels of inflation would be a mistake.
Seemingly mindful of its role in the economy and its dual mandate of maintaining price stability and maximum sustainable employment, the Fed has begun laying out a plan to remove the monetary support put in place early in the pandemic. At the November 2021 Federal Open Market Committee (FOMC) meeting, the Fed announced that tapering would begin this year with a gradual reduction in its monthly purchases of $120 billion in Treasury and mortgage-backed securities. Since that meeting, Powell and other senior Fed officials have made it clear that the FOMC will consider increasing the pace of tapering at its December meeting in light of the elevated and broad-based inflation data reported for November. An earlier end to the taper would provide the Fed with the option to raise rates sooner and faster. Deciding how far and how fast to raise rates poses significant challenges for the Fed. Too far and too fast could lead to a slowdown in the growth rate of the U.S. economy and increased market volatility. Low-yielding, longer-dated bonds would also suffer in this scenario.
How we mitigate risk
While we believe the Fed will act with diligence, our approach to managing your assets is influenced by the possibility that it may raise rates significantly and soon, resulting in an economic slowdown or even downturn. For this reason, we continue to focus on investing in the equities of high-quality businesses with strong franchises that, on balance, have high barriers to entry, pricing power, and, importantly, less cyclicality than the overall economy.
In addition, where appropriate we seek to ensure that clients have fixed-income exposure via a bespoke portfolio of bonds that we believe clients can hold until redemption. We tend to invest in higher-coupon bonds with a moderate duration, keeping average portfolio duration at five years or less. This approach can reduce sensitivity to interest rate increases. At the same time, our emphasis on high credit quality could help dampen the effects of an interest-rate induced economic downturn.
In short, we are confident that skilled portfolio management can go a long way toward mitigating risk, both from inflation and from policy miscalculations by central banks.
1Source: Federal Reserve.
2Source: U.S. Bureau of Labor Statistics.