Economic Monitor – Weekly Commentary
by Scott J. Brown, Ph.D.

The Inflation Outlook and the Fed

January 14, 2022

The Consumer Price Index rose 7.0% in 2021, the largest increase in 40 years. Anecdotal information, as well as the Cleveland Fed’s Trimmed-Mean CPI, indicates a broadening of price increases across categories in the last few months (a contrast to the narrow range of price increases last spring). Inflation is expected to moderate in 2022, but it’s unclear by how much. Still, there’s little doubt that monetary policy is currently too accommodative. Economists and financial market participants anticipate three to four rate hikes this year, which would leave policy still accommodative at yearend.

Food and energy prices were mixed in the final month of 2021. Gasoline prices fell 0.5% (-2.2% before seasonal adjustment, +49.6% y/y) while food rose 0.5% (+6.5% y/y). Food and gasoline have the largest impact on consumer inflation concerns. The University of Michigan’s consumer sentiment survey for early January showed inflation having a larger negative impact for those in the lower third of incomes. Wages have increased, especially for entry-level positions, but wages for the typical worker are not keeping pace with inflation. Hence, we are unlikely to see the kind of wage-price spiral that occurred in the 1970s and early 1980s. The Atlanta Fed’s Wage Tracker showed median wages up 4.5% in December (compared to 3.4% a year ago), well below the CPI.

In the Great Inflation, wages lagged prices, at least initially, but wages eventually rose. The same thing could happen now. However, union membership in the private sector is currently a fraction of what it was in the 1970s and we have a much greater concentration of large firms. Wage bargaining power has shifted toward firms and away from workers.

The oil shocks of the 1970s and early 1980s, kicked off higher inflation. We’ve had several moderate oil shocks since then, which have not led to a higher trend in inflation. Instead, these moderate oil price shocks have tended to dampen consumer spending. Given the increase in domestic oil production, the impact of oil prices is more mixed these days. The point is that the higher inflation we have been experiencing may be more likely to dampen consumer spending in 2022. If that’s the case, softer demand would help to relieve inflation pressures.

The federal funds target rate range is 0-0.25%. Monetary policy is far from neutral, and has become more accommodative as inflation expectations have ticked up. It’s real (inflation-adjusted) interest rates that matter. Moreover, while the Fed has tapered its monthly rate of asset purchases, it is still buying (adding accommodation). A neutral federal funds rate would be above 2%. Yet, no one expects the Fed to get there anytime soon.

The Fed does not want to surprise the financial markets. Raising rates too aggressively would risk financial instability – not a drop in the stock market or a rise in bond yields (these are not the Fed’s concern) – rather, that we could see more unsettled credit conditions. So, the Fed will move gradually, and telegraph moves well in advance. Currently, the Fed is expected to raise rates once a quarter, beginning in March, May, or June. However, the correct answer regarding Fed policy is always “it depends.”

At the December Federal Open Market Committee meeting, officials discussed the possibility of raising short-term interest rates, but also when to begin reducing the size of the balance sheet (currently $8.8 trillion). Balance sheet run-off would accomplish two goals. It would have an economic impact like a hike in short-term interest rates and it should prevent the yield curve from flattening (or possibly inverting). In his renomination hearing, Powell indicated that balance sheet run-off would likely begin later this year.

The Fed’s decision-making is complicated by several issues. One is that the economic data are notoriously quirky in January and February, reflecting the end of the holiday shopping season, the weather, and seasonal adjustment (and seasonal patterns have been altered by the pandemic, but are not reflecting in the government’s data adjustments). The virus remains a wildcard. Omicron has had a sharp impact on leisure travel, hotels, and restaurants in recent weeks, but given the surge in cases, it may burn through quickly. However, it is likely to be a bigger problem outside the U.S. (especially in China, where vaccines are less effective), further disrupting supply chains and adding to inflation pressure. The reduction in purchasing power for the typical worker may reduce the outlook for consumer demand, and the Fed could remove policy accommodation more slowly. Increased labor force participation could help to reduce strains in the labor market. Powell noted that the best way to encourage labor force participation would be to extend the economic expansion.

In short, there is a lot of uncertainty in the outlooks for the economy and Fed policy. However, the picture should clear up as we roll into the spring months and seasonal noise begins to fade. Expect a lot of second-guessing between now and then.

The Fed’s Beige Book noted that economic growth expanded at “a modest pace” in the final week of 2021. However, demand for materials and labor “remained elevated.” Omicron led to a sudden pull back in leisure travel, hotel occupancy and patronage at restaurants. Contacts reported “solid growth in prices charged to customers, but some also noted that price increases had decelerated a bit from the robust pace experienced in recent months.” Ongoing labor shortages and associated wage growth added cost pressures.

The Consumer Price Index rose 0.5% in December up +7.0% y/y – the largest increase in nearly 40 years. Gasoline prices fell 0.5% (+49.6% y/y), while food rose 0.5% (+6.3% y/y). Ex-food & energy, the CPI rose 0.6% (+5.5% y/y), reflecting increases in used vehicles (+3.5% m/m, +37.3% y/y) and shelter (+0.4% m/m, +4.1% y/y). The Cleveland Fed’s Median CPI rose 0.4% (+4.8% y/y), consistent with broader price increases.

The Chicago Fed Advance Retail Trade Summary (CARTS) indicated that sales ex-autos fell 2.3% in December.

Retail sales fell 1.9% in the initial estimate for December (+16.9% y/y), down 2.3% ex-autos (+18.8% y/y), matching the CARTS data. Ex-autos, building materials, and gasoline, sale fell 2.8% (+17.0% y/y). Seasonal adjustment likely exaggerated the December decline, but the drop may reflect earlier holiday shopping, the Omicron variant, or a decrease in purchasing power for the average consumer.

Business inventories rose 1.3% in November (+8.7% y/y). Business sales rose 0.7% (+17.6% y/y). The inventory balance has been largely concentrated in motor vehicles. Note that the change in inventories contributes to the level of GDP. The change in the change in inventories contributes to GDP growth. That is, if inventories rise at a faster pace (after adjusting for inflation) or falls at a slower pace, that adds to overall growth. If inventories rise more slowly or fall more quickly, that subtracts from GDP growth.

Industrial production slipped 0.1% in December, partly reflecting a 1.5% drop in the output of utilities (warm weather). Manufacturing output fell 0.3% (+3.7% y/y), with auto production down 1.3% (-5.9% y/y). Ex-autos, factory output slipped 0.2% (+4.6% y/y and up 1.6% from two years earlier). Supply chain issues may have limited production in December.

The Producer Price Index rose 0.2% in December (+9.7% y/y), reflecting a 0.6% decline in food (+12.9% y/y) and a 6.1% drop in wholesale gasoline prices (+65.8% y/y). Trade services rose 0.8% (+13.3% y/y). Ex-food, energy, and trade services, the PPI rose 0.4% (+6.9% y/y).

Jobless claims rose to 230,000 in the week ending January 8 (419,466 before adjustment, with the season spike higher than in 2019 and 2020). Omicron may have been a factor.

The University of Michigan’s Consumer Sentiment Index fell to 68.8 in mid-January (the survey period ran from December 27 to January 12), vs. 70.6 in December and 67.4 in November. The Omicron wave contributed to the weakness, but inflation remains the more important issues. Weakness was more pronounced from households in the bottom third of income, as inflation erodes a larger portion of income.

The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.

All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.

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