Taming Inflation Will Take Longer Than Expected
By MICHAEL PATON
A recent report by the Brookings Organization, a Washington, D.C. think tank, indicated that the Federal Reserve likely would need to push unemployment far higher than originally thought (4.1%) if it is to succeed in bringing inflation down to its 2% target by the end of 2024. Federal Reserve policymakers as well as most economists had expected that the upturn in inflation that began in March 2021 would prove transitory. They were wrong.
The paper cited several reasons why those expectations proved to be optimistic. For starters, unforeseeable events occurred, namely Russia’s invasion of Ukraine and its effects on global energy prices. Then there’s the persistence of pandemic supply-chain disruptions, driving up prices for consumer goods. Also, there’s the failure to account for the pass-through of specific price shocks (such as energy
and auto prices) into the core or underlying rate of inflation. Finally, there has been a misunderstanding of the strength of the job market.
Inflation is defined as a rise in prices, which can be translated as the decline in purchasing power over time. The rate at which purchasing power drops can be reflected in the average price increase of a basket of selected goods and services over a defined period of time (the Consumer Price Index for example). The rise in prices, which is often expressed as a percentage, means that a unit of currency (say the dollar) effectively buys less than it did in prior periods. Inflation can be contrasted with deflation, which occurs when prices decline and purchasing power increases. A price rise means that one unit of money buys fewer goods and services. This loss of purchasing power impacts the cost of living for the public, which ultimately leads to a deceleration in economic growth. In short, the consensus view among economists is that sustained inflation occurs when a nation’s money supply growth outpaces economic growth.
Hopes that inflation would start to decline have been dashed by recent monthly reports by the U.S. Bureau of Labor Statistics, which show that the Consumer Price Index was significantly higher than expected. For example, on an annual basis, the CPI was up 8.3% in August over the prior 12 months, disappointing expectations for a lower figure. Although an improvement from July’s annualized 8.5% gain, it remains too high for price stability as defined by the Federal Reserve Board.
In particular, food prices were a sore spot rising much faster than expected, although, the gasoline price index fell by 10.6% in the month furthering a late summer decline. So-called core CPI, which strips out volatile food and energy prices, saw a bigger increase in August. Core CPI rose 0.6% over the month and is 6.3% higher than the 12 months prior. The stickiness of core CPI though, will likely tell the central bank if more rate hikes are needed, especially after Federal Reserve Chair Jerome Powell’s recent speech in Jackson Hole, WY.
Inflation has been the Federal Reserve’s number one enemy in 2022. The Federal Open Market Committee has made aggressive changes to U.S. monetary policy to bring inflation down to its long-term target of around 2%. Tackling inflation, however, may bring harm to the U.S. economy. Rising interest rates increase borrowing costs for companies and consumers, weighing on economic activity.
Up to this point, the U.S. labor market has been solid, but the S&P 500’s year-to-date weakness reflects concerns on Wall Street that the economy may not take spiking interest rates in stride. In addition, growth stocks are particularly sensitive to rising interest rates because fund managers typically use discounted cash flow models to determine their price targets for growth stocks. Future cash flows are considered less valuable when the discounted rate is higher.
Although recent inflation reports have been disappointing, there are some positive developments as well. First, gas prices have continued to fall and will continue to push down headline inflation. Second, inflation expectations have dropped recently, and falling gas prices should also help that continue. Third, wage growth isn’t taking off too much, staving off some concerns about a wage-price spiral. Finally, global supply chain pressures (although still very much concerning) continue to unwind.
Nonetheless, there is clearly a way to go before inflation is tamed.
About the author: Michael J. Paton is a portfolio manager at Tocqueville Asset Management L.P. He joined Tocqueville in 2004. He manages balanced portfolios and is a member of the fixed-income team. He can be reached at (212) 698-0800 or by email at MPaton@tocqueville.com.