Higher Inflation and Higher Interest Rates: Get Used to it

Last May I wrote that our economy is entering a new thirteen year cycle that would be characterized by higher inflation and higher interest rates. (See:Shulmaven: The U.S. Economy is Entering a New Thirteen Year Cycle ) In that post we noted that the forces of deglobalization and decarbonization were inherently inflationary which would increase the demand for capital, and hence real interest rates. Whether or not there was a global savings glut, the demand for capital would mop up whatever excess savings there is.

In this post we add a third factor. Real wages have collapsed as inflation of 8% has swamped wage gains of 5%. Trust me, there is going to be a catch up which will put pressure and corporate margins and pricing. This will hardly make for a good environment for both interest rates and stock prices. 

Further although money growth has slowed dramatically over the past year, the 25% annual rate of increase in M2 over 2020 and 2021 will provide more than enough fuel to ratify the price increases that are coming.  As a result instead of having the wind at its back, the Fed will find it increasingly difficult to bring inflation down to its 2% target.

Way Too Complacent about Inflation and Rates

This morning the BLS reported that the CPI increased by 0.5% and the core CPI increased by 0.6% in December. On a year-over-year basis prices are up 7.0% and 5.5% for headline and core, respectively. The data came in somewhat higher than expected, yet both stock and bond prices rallied figuring that inflation has peaked and will gradually retreat througout the year, especially with the Fed signalling three or four rate hikes over the balance of the year.

I agree that we are roughly at the peak in the year-over-year inflation rate, but where I disagree is that inflation will likely running between 4-5% on a year-over-year basis in December. Why? The runrate for both owner's equivalent rent and tenant paid rent is currently 5% and that will likely increase to above 6% compared to the recent year-over-year rates of 3.8% for OER and 3.3% for tenant paid rent. Similarly medical services which increased at a mere 2.5% YOY is now increasing at at 3.6% rate and likely to go much higher given the labor shortages in that sector. Underneath all of this is that average hourly wages increased at 4.7% YOY in December, but the current runrate is more likely in the 6%-7% range. 

What this means is that sometime midyear, the Fed will wake up and instead of increasing rates at a measure 25 bps a quarter, there will be a surprise 50 bps increase. That, to say the least, will shock the markets.

Too Complacent about Inflation

Over the past two months both the stock and bond markets have become far too complacent about the prospects for inflation. Indeed, after the Fed announced that it was talking about tapering, bond prices rallied sending the 10-year U.S. Treasury yield below 1.5%, well off from its 1.74% high. After the break in lumber, iron ore and copper prices the market has bought in hook-line and sinker to the Fed’s view that the recent uptick in inflation is transitory.

 

In my view the markets are way too complacent. Why? There are two long term and very sticky factors that will keep inflation well above 3% over the next few years. The first factor is that the reported owners’ equivalent rent component of the consumer price index increased at a very modest 2.1% from May 2020 to May 2021. However, in the real world according to CoreLogic single family home rents increased by 5.3% over the same time period. Thus, the official CPI has lots of catching up to do.

 

Second, although average hourly earnings for nonsupervisory workers increased at a modest 3.4% annual rate from December 2020 to May 2021, if you look under the hood wage gains are far from modest. For example, over the same time period the annual rate increase for manufacturing wages was 11.5%, leisure and hospitality 13.2%, construction 5.2%, professional services 6.4% and the much-maligned retail sector 4.8%. The low topline increase in wages is a result of mix change as lower wage workers reenter the workforce.

 

The market seems to be ignoring these data at its peril. Part of the reason, I believe, is institutional inertia; money managers are reluctant to make an out of consensus bet on inflation, because if they are wrong, it would become a career ending event. As a result, by this Fall much of the transitory factors may well have run their course, but the longer-term inflationary forces will come to the fore to the chagrin of most market participants.

My Amazon Review of Raghuram Rajan's "The Third Pillar: How Markets and the State Leave the Community Behind"

Inclusive Localism

Raghuram Rajan, a University of Chicago finance professor, former Governor of the Reserve Bank of India, former Chief Economist at the IMF and the one who blew the whistle on the dangers embedded in the derivatives markets at a 2005 Federal Reserve conference has written an important book on the political crisis of our time. Unfortunately it is too long and too dry. That said he is spot on in noting how the state and the market has taken over the historical role of community in our society. No wonder folks are alienated.

He focuses in on the communities that have been left out of the global economy over the past fifty years from rural towns, isolated factory communities and the inner city. All of this being exacerbated by a flood of immigrants who put downward pressure on low end wages and upward pressure on rents and the geographic sorting of the global elites in very expensive neighborhoods and metropolitan areas making upward mobility difficult. Because the major urban centers have become so expensive Rajan focuses on place-based strategies as opposed to people-based strategies to uplift the left behind. He focuses on what he calls “inclusive localism.” By that he means that wealthy communities have to affirmatively loosen up their planning controls and society as a whole has to invest in infrastructure in poorer communities.

However this is all too easy to say and very difficult to implement. Wealthy communities are not opening their doors and for poorer communities to uplift themselves there has to be a requisite amount of indigenous leadership ready and willing to take charge.

My own view is that inclusive localism would be far easier to implement if we returned to the 100 year old ideology of the melting pot. I know this is not politically correct, but it largely worked for white America and probably can work for all of America today. If we are to have inclusive communities there is going to have to a lot give from all corners. It sort of comes down to that old saying of “think globally and act locally.” Further it would help if we had a program of national service where young people of different backgrounds are forced to work together on common goals and it would also help if the elite universities radically increased their class size to accommodate more students.

Rajan closes the book with his global solution to today’s economic problems. To me that is a bridge too far and ought to be the subject of a different book.

For the full amazon URL see: https://www.amazon.com/review/R1XE3YT1K4PGS9/ref=pe_1098610_137716200_cm_rv_eml_rv0_rv

The Fed Will Get the Inflation it Wants

Bye bye data dependence. The data were there for the Fed to make
hawkish comments; core inflation is moving up (now 2.3% yoy on core CPI) and the economy is operating at full employment. Nevertheless the Fed chose to punt by cutting back on its outlook for future rate hikes. Why? It looks like the FOMC members want to over-shoot their 2% inflation target and light a fire under wages. They will soon get their wish.

In response materials and energy led the charge on the stock market, the dollar weakened and the yield on the 2-year note collapsed. It would seem to this observer that TIPS make a great deal of sense today.

"The Inflation to Come in Housing, Healthcare and Wages," UCLA Economic Letter, January 2014

 For the past year, U.S. inflation has remained at very low levels. But that is about to change, led by price increases in housing and healthcare, and by modest wage increases. And that will eventually cause the Fed to abandon its zero interest rate policy.

“Rent controlled jurisdictions (i.e. New York, Los Angeles, San Francisco and Washington, D.C.) are over- weighted in housing price indices. As a result, housing inflation will accelerate as controlled rents are marked to market through vacancy decontrol. Furthermore, 2014 will bring with it the eighth year of under-building.”

As a result, the combination of higher housing costs, a modest snap back in health care inflation and moderate wage increases will soon push inflation up from the extraordinarily low level of the past year. Instead of having a very low inflation rate of 1%, we will soon be witnessing a low inflation rate of 2%. The Fed wants this increase and it will get it. The uptick in inflation combined with an improving labor market will cause the Fed to abandon its zero interest rate policy in early 2015.




For the full article go to the following URLs:
http://www.anderson.ucla.edu/centers/ucla-ziman-center-for-real-estate/research-and-faculty/ucla-economic-letter

or

 http://www.anderson.ucla.edu/Documents/areas/ctr/ziman/UCLA_Economic_Letter_Shulman_01-16-14.pdf