Historic inflation will force Federal Reserve’s hand in 2022
First a pandemic, then supply chain disarray, and an unprecedented round of accommodative monetary policy tied with massive fiscal stimulus packages. January’s headline Consumer Price Index (CPI) print was 7.5% over a year ago, the highest level since 1982.
To put this in perspective, Super Bowl MVP Cooper Kupp would not be born for nine more years, Mary J. Blige was eleven, and the Billboard Hot 100 included names such as Hall & Oates, Foreigner, and Stevie Nicks with Don Henley. Simply put, there is a great deal of society (not to mention money managers and policy makers) that has not experienced this level of inflation in their lifetimes.
For us students at Colby, we have never known a world where the CPI reading is anywhere but right around the Fed’s preferred 2% gauge.
To make matters worse, the core CPI, which excludes volatile components of food and energy, increased 6% over the last year. This represents broad inflation across multiple components.
While the initial jump in inflation midway through 2021 was contained to “reopening categories,” attribution to this phenomenon has diminished as the global economy better learned to live with COVID-19.
Some of the highest increases are among used cars and trucks and new vehicles, which increased nearly 41% and 12%, respectively. These two categories are generally some of the calmest components of the CPI — unprecedented supply chain disruption has had some effect on these markets.
In 2021, massive semiconductor shortages, for example, forced the hand of many automakers globally to curb production and cull inventories. This shortage had a pass-through effect on the used car markets, where fewer trade-ins led to booming prices for older vehicles.
The component for shelter, which represents rent and housing costs, has increased 4.4% year-over-year.
We all have observed inflation at the gas pump, as curbed shale production in the United States along with constrained supply from the OPEC+ nations have skyrocketed the West Texas Intermediary futures price above $90 a barrel, the highest level since 2014.
The component representing food has increased 7% over the last year. These three categories (shelter, gasoline and fuel oil, and food) are what hurt Americans the most due to their relatively inelastic demand.
In addition, there has been heightened demand in many categories due to the fiscal stimulus programs.
Clearly, we have potential causes for this inflationary setting in the form of shortened supplies (cost-push) and an economy awash with liquidity and monetary support (demand-pull). However, the overall effect of each factor is difficult to address.
The bond market has been very active since the outset of 2022, with the yield on a 2-year US Treasury increasing rapidly by 90 basis points. The more-commonly studied 10-year Treasury is yielding 1.96%, surpassing pre-pandemic levels.
The rapid and volatile moves across the curve have led some to say the Fed is now behind in their response, but the policy-making institution has signaled that there will be further tapering paired with rate hikes in 2022. The question now looms: when and how much?
With each month of heightened inflation, rate hikes implied by the sentiments of Fed officials and financial market participants increase. Not that long ago, the Fed’s dot plot (which displays predicted rate hikes by each member of the Board of Governors) implied little to no change in policy during 2022. Now, some are calling for a 50-basis point hike as soon as March.
The Fed has all the proper tools to cull inflation — the days of Paul Volcker prove that. However, the situation of 1982 is vastly different than that of today.
The components of the CPI have changed, the global economy functions completely differently, and the methods by which Americans can consume have been altered by technology forever.
Most importantly, we are still in a pandemic. Due to the Omicron variant, it is estimated that nearly 14 million Americans missed work at some point in January. The effects on the global economy, especially supply chains, are vast and dynamic in nature.
Powell’s Fed must be careful to not take too much liquidity out of an already-fragile economy. Conversely, the highest inflation in nearly forty years demands action.
~ Cam Dyer ‘22
