Finally, after years of waiting, the economy is starting to show signs of significant inflation. Powell seems to have little concern with inverting the yield curve and even more pundits are pointing to a market correction. On the opposite end, some financial pundits are painting a different narrative. One where the Fed ignores its 2.0% inflation mandate, and the economy runs hot to make up for the last decade of poor growth.
Which narrative wins out is anyone’s best guess, so HiddenLevers decided to analyze the good, bad and ugly of inflation. The post will summarize our findings and discuss the effects of inflation in the US and globally.
The Good: Pricing Pressures Ease
The most obvious way the Fed can stay the course and continue their regime of accommodative monetary policy is for pricing pressures to ease. Imagine a world where commodities such as oil move back towards their 2016/2017 lows and the furious pace of home price appreciation eases. In this world the Fed can put the brakes on normalizing monetary policy and continue with their low rates regime.
Luckily, there are a couple of catalysts pushing the economy in this direction, for one oil prices have moved up due to tensions with Iran and unrest in Venezuela. If US producers are able to fill the gap, oil prices may remain muted, which would ease inflation pressures.
Caption: Oil Prices have appreciated on the back of global unrest, not global demand
In this scenario expect for CPI to hover around the Fed’s 2.0% target and GDP growth to continue on its upward trajectory.
Baseline: Symmetric Inflation
The newest buzzword in monetary policy is “symmetric” inflation. The term popped up in the FOMC’s May statement. The buzz around the statement is important because it implies that Fed may let inflation creep past their 2.0% target to account for the past decade’s low inflation numbers.
Caption: Wages are finally starting to grow, as the labor market tightens
In this scenario expect the domestic equity market to remain mostly flat and CPI to creep closer to 3.0%. Wages will continue to grow, and unemployment will stay at its historically low level as GDP continues to appreciate.
Ugly: The Fed Falls Behind
While there may be some advantages to letting inflation run past 2.0%, if the Fed is too lax with its monetary policy the US could end up reliving the late 1970s. In this scenario expect interest rates and commodity prices to move higher in the short term, and poor equity returns in the long term as the Fed moves aggressively to crush inflation. High inflation on its own will not cause a recession in the US, but whatever moves Powell makes to curb CPI could cause a recession down the road.
Keeping your eye on the ball
While many investors become distracted by the current news cycle, it is important to not lose focus of the bigger picture. The new Fed president and his goal will to normalize monetary policy will have an effect on the economy for years to come.
If you’re curious about how inflation will affect your portfolio going forward, you can stress test your portfolio using HiddenLevers for free.