FINANCIAL MARKET UPDATE 5.18.2021

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

THE INFLATION DEBATE EXPLAINED

An intense debate has been raging in the markets centered on whether the economy is entering a new regime of persistently higher inflation. More fuel was added to the fire last week when a new economic report showed prices have been rising at the fastest pace since 2008. The burning question focuses on whether rising inflation is the temporary result of the economic recovery or if fiscal spending and loose monetary policy will lead to a longer-lasting change.

Inflation and Monetary Policy

A major reason the developing inflation story is critical to the markets arises from its implications for the Federal Reserve and monetary policy. The Federal Reserve has a dual mandate of maintaining price stability and maximizing sustainable employment. While this may seem pretty straightforward, doing this successfully is complicated by the relationship between employment and inflation. Generally, actions taken to support employment can create unwanted pressures that accelerate price increases. Similarly, actions take to cool rising prices could restrict growth in employment. A delicate balance is required to simultaneously achieve both mandates.

An important lesson that policy-makers took from the Financial Crisis of 2008-09 was the high cost of not doing enough to support the economy. Absent sufficiently accommodative policy, scaring in the economy caused by a large number of business and household bankruptcies can hamper the subsequent recovery for years. At the time, people feared that the still considerable level of spending and monetary stimulus would lead to rampant inflation. These fears never materialized, however, with the Fed’s preferred inflation gauge (PCE) running persistently below their long-term objective of 2%.

In the aftermath of another devastating economic crisis, Fed officials are determined to minimize the scaring. To support economic recovery, the Federal Reserve is holding its benchmark interest rate near zero and is purchasing $120 billion in bonds each month. Despite widespread signs the economic recovery has firmly taken hold, the Fed is keeping its foot on the gas. Fed officials have indicated the intention to maintain these policies, “Until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.”

The Debate

The vaccination program has allowed the economy to move towards fully reopening. As this happens, rising demand and bottlenecks in the supply chain have led to an acceleration in inflation. The increase in inflation is expected to be amplified over the course of the spring due to something known as the “base effect.”

Inflation is calculated as the year-over-year change in prices. One year ago, the economy was being locked down to combat the pandemic, which put downward pressure on prices at the time. Comparing today’s prices to the weak ones from a year ago exacerbates the perceived rate of increase. Other contributing factors include labor shortages, wage pressures, logistical issues like insufficient shipping containers, and a global shortage of microchips.

The major question is where inflation is going from here. Specifically, whether these price pressures will be persistent or just a temporary blip. Economists that believe higher inflation is here to stay typically make an argument the boils down to ‘too much money chasing too few good’s.’ This is something I talked about in a previous post that you can read (Here). The general idea is that the Fed is contributing to the “too much money” issue and that they should dial back now before the problem entrenches itself and becomes difficult to combat.

Generally, high inflation leads people to expect continued high inflation. These expectations change behavior, leading workers to demand higher wages to compensate for lost purchasing power, causing businesses to raise prices to cover the higher wage costs. Higher expected inflation can lead to higher actual inflation in a vicious cycle that is difficult to break.

The Fed, on the other hand, believes that the price pressures are “transitory.” They argue there is significant slack in the economy, which refers to the high level of unemployment (people who want to work but can’t find a job) and wide output gap (what the economy is producing versus what it is capable of producing). In this environment, it is difficult to sustain higher inflation, because additional capacity can be put to use, which would result in a downward pressure on prices. Finally, there are structural factors that are believed to be contributing to the downward pressure on inflation over the last decade. These include demographic trends, globalization, and technological advancements.

The inflation debate is likely to remain front and center for the next couple of months. Even if it proves to be temporary, the uptick could persist for some time. The Federal Reserve is resolved to maintain its policy stance, but it will be under intense pressure to reverse course if the market judges that it has lost its grip on inflation.

WEEK IN REVIEW

  • The Bureau of Labor Statistics published the April Consumer Price Index (CPI) data last week. According to the report, inflation increased 4.2% YoY, which was much higher than economists were forecasting. Core prices, which exclude the volatile food and energy categories, increased 3% YoY. Leading the way higher were used cars and trucks, which saw prices rise by 21% over the last 12 months. Much of that increase has been attributed to the shortage in microchips, which has caused production cuts across auto manufactures. With a lower supply of new vehicles, there has been an increased demand for used vehicles, pushing prices dramatically higher.
  • Economic data to be published this week includes the minutes from the last FOMC meeting on monetary policy, due on Wednesday. On Thursday we will get an update on jobless claims and the Index of Leading Economic Indicators. On Friday we will get an early look at manufacturing and service sector activity with the Markit Flash PMI reports. Finally, there will be a host of Fed officials speaking throughout the week. The market will be watching these closely for clues on how the Fed is perceiving new data and what impact that might have on forward guidance.
  • According to Factset, 91% of companies in the S&P 500 have reported first-quarter earnings as of last Friday. 86% of these firms have beat earnings estimates, while 76% beat revenue estimates. If you blended the growth rate for companies that have reported earnings, with the estimates of those who have yet to report, YoY earnings growth in Q1 would be 50.3%. This is dramatically higher than the forecast earnings growth rate as of 3/31/21 (23.7%) and would be the highest growth rate since the first quarter of 2010 (55.4%).

HOT READS

Markets

  • U.S. Shoppers Continued Stimulus-Fueled Spending in April (WSJ)
  • Economist Calls for Calm on Inflation Talk (CNBC)
  • Homebuilder Confidence is High, But Rising Costs of Materials Present Major Risks (CNBC)

Investing

  • What Michael Jordan can Teach Us About Investing (Morgan Housel)
  • The Speculative Cheerleaders Face a Reddit Reckoning (Bloomberg)
  • There Can Be No Safe Dependable Way to Make a High Return in a Low Return World (Yahoo Finance)

Other

  • The Real Story Behind Netflix’s Top 10 List (Vulture)
  • Cheating at School is Easier Than Ever- and It’s Rampant (WSJ)
  • Private Equity Bets on Sports May Not All Be Winning (Institutional Investor)

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

ECONOMIC CALENDAR

Source: MarketWatch

Do you want to receive financial market updates in your inbox? Sign up here! 

ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

LINKEDIN

JOSH JENKINS, CFA + CHIEF INVESTMENT OFFICER

Josh Jenkins is the Chief Investment Officer at Lutz Financial. With 10+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. In addition, he is responsible for portfolio trading, investment research and thought leadership for the division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

P: 402.827.2300 | F: 402.827.2319 | E: contact@lutzfinancial.com | 13616 California Street | Suite 200 | Omaha, NE 68154

All content © 2017 Lutz Financial  | Important Disclosure Information |  Privacy Policy

FORM CRS RELATIONSHIP SUMMARY