Note: The content in this article is based on Fifth Third’s current assessment of global markets and economic signals. It reflects the same ideas shared in conversations with Fifth Third clients, but does not constitute investment advice.
Jeffrey D. Korzenik, Chief Investment Strategist for Fifth Third Bank
There is no more serious threat to the U.S. economy than inflation. Spiraling higher prices risk an unsustainable environment. Possible outcomes include real consumer purchasing power falling faster than wages rise, consumer and business confidence eroding, curtailing spending and investment, and a Federal Reserve forced into "slamming on the brakes," aggressively raising interest rates. In other words, if inflation persists, the U.S. economy is heading into a recession. But that’s only if inflation remains unconstrained, something neither a certainty nor, in our view, the most likely outcome.
The Components of Inflation
The classic formulation of inflation is the result of "too many dollars chasing too few goods." So, is our current inflation the result of "too many dollars" or "too few goods" or both? Dissecting the components provides insight into the future path of prices and our economy.
A general price rise associated with "too many dollars" is more formally called, "demand-pull inflation." While demand-pull inflation is associated with rapid money supply growth, it is not always the direct result of monetary policy. Indeed, our rapid growth in money supply—and subsequent elements of demand-driven inflation—was primarily driven by policy choices outside the control of our central bankers. Stimulus checks, augmented unemployment benefits, student loan and rent moratoriums, aid to businesses, federal aid to state/local governments and the lockdown of spending outlets during the Pandemic created both a record accumulation of cash and a substantial amount of pent-up demand.
Demand-pull inflation also tends to slow as producers of goods and services respond to higher demand with higher supply, stabilizing prices. For example, it is often said that, "the cure for high commodity prices is high commodity prices," reflecting the way that higher prices incentivize the production of more goods. To the degree that demand-pull inflation is the culprit, the Fed had a point in expecting these pressures to be transitory.
Alas, the Fed only looked at half the picture, and underestimated the degree to which supply constraints delayed increasing production. Moreover, the economy has been faced with distinctive supply shocks that have driven prices higher and threaten to stoke further inflation.
From the early months of the pandemic, the "too few goods" element of inflation was also driving higher prices. In the spring of 2020, many businesses reduced inventories in anticipation of weak demand; but government support sustained demand beyond expectations through most of the past years and retailers could not keep pace with the surge of reopening demand. Overlayed on the inventory shortage was the bottleneck within the supply chain, most notably in the Southern California ports through which so many goods from Asia enter. Many industries were ill-equipped to adjust to the rapid shifts in consumer behavior during the pandemic, causing shortages. Finally, the Russian invasion of Ukraine and the ongoing Western policy response is pointing to shortages in goods as diverse as wheat, oil and neon (an industrial gas critical to lasers used in the production of semiconductors).
In theory, time will solve many of these shocks as supply chains adjust. But supply chain shifts take time and also involve costs; as companies seek more resilient supply chains it may come at the expense of some of the disinflationary benefits of globalization.
Risks and Challenges of Inflation
One supply shock is not easily solved: the labor shortage. Based on the slow birth rates of 20-30 years ago, a labor shortage had been looming. The pandemic made what would have been a gradual process into a sudden crisis as workers unexpectedly exited the labor force. Among the losses certainly were people who chose to leave to raise children or to care for parents, but the single biggest loss was the estimated two million older workers who retired early. While some will return, many will not. At present, the U.S. economy has roughly eleven million job openings but only six million job seekers—a historic net shortage of five million workers. The inability to fill job openings is closely associated with wage increases that can challenge corporate profitability and, if sufficiently large and persistent, lead to inflation.
The labor shortage is serious, but not insurmountable. While part of the solution will come from greater deployment of robotics and other automation, employers can help themselves by rethinking their talent strategies: eliminating superfluous credential requirements for applicants, offer the flexibility so valued by working parents, and create pathways for individuals overlooked or marginalized from the workforce. Immigration offers another possibility, but employers have limited ability to impact policy and the demographics of a labor shortage cuts across many, many countries.
A supply chain that is not solely focused on cost reduction implies a higher base rate of inflation going forward. An ongoing labor shortage also implies a higher base rate of inflation going forward. While the Federal Reserve may no longer have last decade’s worry about deflation, this new baseline carries its own challenges. The Fed has repeatedly cited the importance of inflation expectations being "well-anchored" as a key to fulfilling its mandate of price stability. Consumer and business expectations for inflation contribute to actual price outcomes, and a higher base environment can reasonably be expected to change those expectations, and the Fed will need to ensure that they do not get reset to levels that are unacceptably high. High long-term inflation expectations are hard to combat once embedded; the early 1980s required two Fed-induced recessions to bring expectations under control.
The Good News and Bad News
We see significant progress in alleviating some of the drivers of inflation. Money supply growth in recent months has returned to pre-pandemic levels as various federal relief programs have expired. Domestic oil production continues to rise and the U.S. Energy Information Administration projects all-time high production by the end of next year. Home prices are still advancing, but at a less frenzied pace, as higher mortgage rates and high prices deter demand. Excluding the supply-chain challenged auto sector, retailers have rebuilt inventories substantially, to the level that deflationary price discounting may lie ahead; although the broader measure including autos is not as encouraging, we can see that the critical inventory-to-sales ratio at least appears to have bottomed. Shipping costs from China to Southern California have stabilized and the long line of ships waiting to enter the ports of Long Beach and Los Angeles has shortened dramatically.
Even in the very challenging labor markets, there are signs of improvement that should ease inflationary pressures. Payroll growth has been strong, as job seekers adjust their earlier expectations to match the reality of the current job market. Better yet, the labor force participation rate is rising, further helping ease some of the wage inflation. Given the way that labor shortages have played a role in supply chain challenges (lack of truckers, for example), rising payrolls may actually be disinflationary in this strange cycle.
To date, the Federal Reserve has been very successful in managing long-term inflation expectations. Even as consumers have reluctantly accepted the prevalence of inflation over the short term, over a multi-year view, they expect inflation to subside to levels well below three percent, matching market-based calculations. It’s worth noting that we can infer from stable credit conditions that a moderation of inflation is expected without a recession.
Unfortunately, this constructive view must be balanced against potential risks. Money supply growth has slowed, but excess money market mutual fund balances remain in the trillions of dollars and consumers retain the ability to leverage; demand-driven inflation is not yet done. Home price appreciation may be slowing, but there is a lag until rents and OER (owner equivalent rent), among the largest components of the CPI index, actually see moderation.
Supply chain disruptions may have lessened, but some of that has been on the back of seasonal factors that are starting to turn. Future potential problems lie ahead from the expiration of the California Longshoreman's Union contract on July 1. The current covid-related lockdowns in Shanghai and now Beijing will likely also strain supply chains once again.
What’s a Central Banker to Do?
Against this backdrop, the Federal Reserve Bank is in a difficult position. Typically, we enter a Fed tightening cycle when we start to run out of labor at the end of a multi-year expansion and have relatively high debt burdens. Today we are only a year past the time our GDP recovered from the downturn of early 2020, we have millions of job seekers and the kind of rising labor force participation that policymakers want to foster, and both corporate and household debt burdens are highly manageable. Yet, the Fed must address inflation. Our expectation is that the Fed will be very aggressive in its anti-inflation messaging and in lifting the fed funds rate to a "neutral" level (neither restrictive nor expansionary), estimated to be about 2.4%. This is consistent with the aggressive 0.50% rates hikes currently being discussed.
The question will be whether the Fed continues on such an aggressive path once a neutral level has been achieved. Our belief is that inflationary pressures will have subsided—not completely—but sufficiently for the central bank to pause or slow the rate of interest rate increases. This prospective path is one that has a substantially lower risk of a recession, and whose economic outcomes would be in line with a typical multi-year expansion.
Unacceptably high inflation is not going away anytime soon, but the forces of inflation are abating. The critical need for the Fed to manage inflation expectations fosters a multi-quarter period of "ugly" headlines of high inflation and aggressive central bank rate hikes. However, a recession is neither a foregone conclusion nor even the base case. Assuming that the Fed can continue to hold inflation expectations reasonably "anchored," our central bank should have more leeway by next year to balance price stability with continued economic growth. Looking through the furor, businesses will continue to add to their payrolls and find alternatives to supply challenges. Consumers will struggle to keep up with inflation over the short term but over the longer term, workers will be empowered and our consumer-oriented economy will advance.