The Fed’s inflation war

Is inflation actually about to peak in coming months?

It is no surprise that the last few months have been jarring for financial markets, now with the additional overlay of geopolitical tensions and near-term macro effects (e.g., a spike in crude oil and other commodity prices) engendered by the Russo-Ukraine war. The Fed, initially believing price spikes were short-term, was caught in an almost cartoon-like backpedal as inflation instead accelerated to a 40-year high. A big hole was blown in their narrative. When Chairman Powell was asked in late 2021 about the Fed’s colossal miss, rather than fumbling around for an articulate response, he was plain spoken: “We can begin to see that the post-pandemic economy is likely to be different in some respects.” Aha!

It was always obvious to us that the Fed had neglected a crucial component in their inflation analysis – overplaying the supply side (bottlenecks and such) and underplaying the demand side (rising household wealth, stronger capital spending and a structurally looser fiscal stance). Adding in the demand part radically changed the calculus: inflation would be stickier as a boom in global aggregate demand would keep prices elevated.

Still, there is a real danger in leaning too heavily on this analysis. The world has just witnessed a huge shift in consensus. Most now expect inflation to be far stickier and far higher than only a few months ago.

But some inflationary dynamics were always bound to be (whisper it) transitory. Why is this? First, base effects. Inflation started accelerating last March, which argues for a peaking out in the next few months. Secondly, growing evidence points toward easing of lockdown-triggered bottleneck issues. The supply side is catching up and shortages are being resolved (albeit at varying speeds). In fact, rather than scarcity, overcapacity lies ahead for some sectors.

All of this will tug prices lower in the period ahead, even as inflation stays more elevated than the last decade. Still, markets react to changes in the margin. A directional change in prices will restore confidence in central bank credibility.

Yet markets remain on edge, concerned that the Fed will tighten too much and short-circuit the recovery. To be sure, that will occur at some point. Monetary tightening is the leading cause of recessions. But some perspective is in order here. At the risk of stating the obvious, interest rates are insanely low relative to the growth and inflation backdrop. The Fed is nowhere close to recession-inducing rates.

The real issue is that most investors are still anchored to the secular stagnation period after 2008 – they simply do not believe the economy can ever escape low rates. But in the 2010s, the need for consumers to repair balance sheets necessitated a far lower interest rate. Today, the U.S. economy is on far firmer footing. What’s more, global demand is set to be supported this year by a large part of the world soon to be cutting rates.

Consider that most central banks in the developing world have already had some of the most aggressive monetary tightening campaigns on record. Brazil has lifted its policy rate from 2% to 10.5% over the last year. Most crucially, the contrast between American and Chinese monetary cycles has become crystal clear this year: the latter is now in full-blown reflationary mode. All of this has created ample room for policy easing as inflation moderates. With global demand surging, a recession is not yet on the horizon.

Does the stock market selloff and rotations have further to run?

Market correlations forged in the Covid laboratory are now breaking down. Technology stocks have been particularly damaged, sparked by the now near-certainty of rising interest rates and a slowdown in digital demand after a pandemic-induced spike. A “great rotation” is underway, favouring the less glamorous, out-of-favour international value stocks at the expense of US growth stocks.

This is new terrain to navigate. And these trends have further to run. But all of this is consistent with an ongoing investment regime change, from the slow growth and low inflation era of the 2010s to the higher-altitude inflationary boom we now inhabit.

Along with this macroeconomic transition, investment leadership will also change. This is always bumpy as markets attempt to discern the durable trends ahead. But make no mistake, a big shift is here. Strap yourself in – and don’t forget to take your protein pills and put your helmet on.

Tyler Mordy, CFA, is CEO and CIO of Forstrong Global Asset Management Inc., engaged in top-down strategy, investment policy, and securities selection. This article first appeared on Forstrong’s Global Thinking blog. Used with permission. You can reach Tyler by phone at Forstrong Global, toll-free 1-888-419-6715, or by email at tmordy@forstrong.com. Follow Tyler on Twitter at @TylerMordy and @ForstrongGlobal.

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