Viewpoints: May 2022

Bank of England policymakers have been slammed by UK newspapers in recent days for 'being asleep at the wheel'. Spiralling inflation, a 'cost-of-living crisis', a borrowing binge and an overheating labour market are being specifically pinned on lax UK monetary policy. And last week's UK data flow showing a further big jump in inflation, a steeper than expected drop in the unemployment rate and a record high for job vacancies have added more grease to the media's wheels.

But are these criticisms really justified? Well the answer is not quite, and for a number of reasons. The most straightforward reason being that these criticisms are not just being levelled at the BoE. They're also directed at the Fed, the BoC, RBA, ECB, and at many other central banks besides. In other words, many of these issues are globally-rooted and don't have their origins in lax domestic monetary policy.

Global roots

On the other hand, perhaps all of these central banks have been similarly asleep at the wheel during this period? Global monetary policy settings may have been far too loose for too long, particularly during the pandemic period. This could have generated too much money, excessive private sector leverage, and soaring demand. This could have now yielded outsized price pressures, wage price spirals thanks to overheating labour markets and dislodged inflation expectations to boot. If this isn't a wake-up call for policymakers to tighten monetary policy swiftly and aggressively and squeeze these excesses out of the system, then what is?

However, this global narrative and policy prescription doesn't quite hit the nail on the head either. There's no evidence – at the global level – for rampant money supply growth, for excess private sector leverage, or for economic activity more generally that's overheating. Price pressures have been, and still are, emerging due to acute supply side shortages that can mostly be traced to the pandemic or, more recently, to the conflict in Ukraine and China's zero COVID policy. And while a recovery in global demand has admittedly amplified these pressures, it has been fiscal policy – not monetary policy – that's been playing the supporting role.

All things considered, if that analysis is accurate, shouldn't monetary policy now play a bigger role in ameliorating these price pressures and, at the very least, preventing a bad situation from getting worse? This scribe is dubious. If loose and unorthodox monetary policies throughout the post-financial-crisis era failed to generate any consumer price inflation, and isn't really responsible for high inflation levels at present, why on earth should we expect tighter monetary policy to play a restraining role now?

More appropriate policy tools

Fighting the current combination of weak growth and high inflation with higher interest rates will not restore the supply fabric of the world economy not least now that most governments are tightening their fiscal stance at the same time. Surely a far more apt policy response (which admittedly the UK government is leaning toward) would be to use the levers of fiscal policy to alleviate supply-side shortages (e.g. in energy markets), increase an economy's production capacity and shore up the purchasing power of households and companies. By raising the cost of borrowing, tighter monetary policy will impede a supply side investment drive and further derail private sector purchasing power. As such, central banks may well make a bad situation even worse if they were to more actively respond to the pressures facing them from so many opinion formers in the media.

In what follows, we take a look at a few charts accompanied with (mostly) brief commentary reinforcing these messages.

The first chart in figure 1 below shows the strong link between commodity prices and consumer price inflation in the advanced economies over recent years. In short, consumer prices have been rising because input cost pressures have been rising.

Figure 1: Higher commodity costs have pushed up consumer price inflation

The Federal Reserve Bank of Philadelphia's state coincident indexes in April were again almost uniformly strong, with every state seeing gains over the one-, three-, and twelve-month horizons. Over the three months since January Maryland's index rose more than 4 percent, and only 4 had growth less than 1 percent (Oklahoma, Louisiana, Arizona, and Mississippi). The independently estimated national figure of 1.1 percent growth over this period was, yet again inconsistent with the state numbers.

Over the last 12 months 6 states registered gains higher than 10 percent, led by West Virginia's 14.3 percent. Yet again, New York and California were in this group, and the 5.7 percent national figure was not representative of the individual state outcomes.

Maryland's 1.5 percent gain was the highest between March and April, and 5 other states saw increases above 1 percent. On the other side, 7 had gains less than .25 percent.

Nearly all the states set new record highs in April. However, Connecticut, Hawaii, Louisiana, and Michigan (the latter just barely) have yet to match their pre-pandemic highs.

State payrolls were positive in April, with gains comparable to those in March. 11 states saw statistically significant increases from March, with New Hampshire’s 1.0 percent gain the largest. In absolute numbers Texas’s 62,800 increase was the largest. As was the case in the initial March estimates, over the last 12 months 49 states and the District Columbia had statistically significant increases in payroll employment. Delaware was the odd-man out, even though the April 2022 point estimate was more than 1 percent higher than the April 2021 figure). Aside from Delaware, Alabama, Kansas, and Wisconsin were the only states with gains less than 2 percent over that period. Nevada has seen an 8 percent rise, and the aggregate job increase in California was 925,000.

13 states and DC saw statistically significant drops in their unemployment rate in their unemployment rates in April, with Maryland’s .4 percentage point decline being the largest. The range of unemployment rates across the nation is no longer pronounced. Nebraska and Utah both have 1.9 percent rates; the highs are DC’s 5.8 and New Mexico’s 5.3.

Puerto Rico had another solid month, with a 4,700 gain in jobs and the unemployment rate ticking down to 6.4 percent.

Based on the preliminary data from the GDP report, operating profits fell roughly 10% in Q1 relative to Q4. A decline of that magnitude would drop aggregate company profits back to the Q1 2021 level, or nearly $300 billion below the record level of Q4 2021.

The plunge in operating profits reflects a sharp drop in margins. Real operating profit margins for Non-Financial Companies hit a record high of 15.9% in Q2 2021, dropped to 15.2% in Q4, and probably fell 100 to 150 basis points in Q1 2022. To be sure, Q1 earnings reports from large companies such as Amazon, Wal-Mart, and Target confirm a sharp contraction in operating margins due to rising input costs.

More margin contraction lies ahead, especially if the Fed successfully squeezes inflation to 2%, down from 8%, and limits any significant fallout in the labor markets. For reported consumer price inflation to drop 600 basis points over the next year or so, producer prices for many companies involved in production and distribution would drop twice as much, if not more. And if overall labor costs are unchanged, the hit to profit margins, or the ratio of profits from sales after all expenses, will be significant.

Past cyclical slowdowns offer some perspective on significant margin contraction when monetary policy simultaneously slows demand and price inflation. For example, in 2000, consumer price inflation dropped 200 basis points, but producer prices for finished goods and intermediate materials fell between 600 and 1000 basis points. That dropped triggered the most significant cyclical contraction in real profit margins (700 basis points).

The potential disruption to business operations in 2022 is more significant than in 2000 because the Fed faces a bigger inflation problem. That means a substantial decline in operating margins is the most considerable risk to the equity market. Investors forewarned.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

Inflation cycles are complex, with many interconnected parts. Price changes flow unevenly through the distribution and production channels, lifting final product prices. For example, consumer price inflation doubled from 4.2% to 8.3% in the past year. Yet, that surge is directly linked to even more significant price increases for thousands of items in various processing stages. Indeed, producer prices for crude goods rose 48% over the same period, intermediate materials by 22%, and finished producer products by 16%.

Consequently, taming or reversing the inflation cycle is not as simply slowing or ending the price increases for consumer goods and services. Instead, it requires a broad price reversal across various products and services, impacting production, distribution, and retailing businesses. And that "unwind" process is destabilizing and uneven, resulting in liquidity and cash flow squeezes and profit and income declines.

The Fed's immediate goal is to bring consumer price inflation back to a 2% rate. Although there are many paths to a 2% inflation rate, the most common, based on recent experience, is a sharp slowing in consumer commodities (goods) prices, which accounts for 40% of the overall CPI.

CPI commodities (goods) prices have increased by 13% in the past year. Not surprising, these retail prices are nearly perfectly correlated (86%) with producer prices for intermediate materials, which have increased by 22% over the same period. Moreover, the correlation is robust, even removing the volatility from food and energy, with core consumer commodities rising 9.7% in the past year compared to a near 17% increase in core intermediate prices.

A few episodes have occurred, none recently, in which intermediate materials and consumer commodities prices dropped from double-digit increases to near zero. Fueled by restrictive monetary, prices of producer materials and consumer goods fell hard and fast in the mid-70s and early 80s. Both periods, heavily influenced by supply-side shocks, resulted in economic downturns that ran for sixteen months, nearly a half year longer than the average recession of the post-war period.

So it is not surprising to hear Fed policymakers say, "it will be challenging, not easy," to bring inflation back to 2% from 8% without triggering a recession. That's because it's never been done. And very easy to see why.

For a broad set of industries and businesses, equaling nearly half of the economy, there would be a "flash" crash in prices. On average, price increases would drop from annual gains of 10% to 20% in a year to zero. Yet, given the unevenness of price cycles, many firms would even experience price declines. Sharp price reversals would trigger an abrupt drop in revenues and profits, forcing cutbacks in output and labor.

The unwinding of price cycles creates many losers because the Fed is negatively impacting the flow of commerce and finance through its restrictive policy moves. So far, the losers are in finance-- bonds, equities, and crypto, along with increased volatility. However, investors should expect much more since the Fed tightening cycle, which has just begun, needs to crack the many links of the inflation cycle.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

Some have used peak inflation to create the impression that the worse of inflation news is in the rear and that the Fed has less tightening to do than what many expect. Yet, peak inflation says a lot about what the Fed has to do, which should worry the Fed and scare investors.

In three out of the last four decades, the US experienced a cyclical rise in inflation (4% and above) that compelled policymakers to raise official rates in response. It didn't matter if the inflation cycles were broad (the early and late 1980s) or narrow (oil spike in the mid-2000s). But policymakers had to raise official rates above peak inflation on each occasion to squash the price cycle.

No one is thinking the unthinkable that the Fed has to raise rates above the 8.5% increase in consumer prices over the past year. Yet, past experiences provide painful lessons on the level of official rates required to reverse inflation cycles.

Each inflation cycle has common and unique factors. However, many, including Fed officials, have argued that the current inflation cycle has more than a few items lifting prices temporarily. The Bureau of Labor Statistics (BLS) produces a special aggregate series that removes some things people have cited, so it helps remove some of the noise.

For example, BLS published a series of CPI less food, energy, shelter, and used car and truck prices. This series removes the recent temporary spikes in food and energy prices linked to the Russian invasion of Ukraine. It also removes the massive spike in used vehicle prices associated with supply bottlenecks owing to the pandemic. Yet, this dumbed-down price series still shows a 5.8% in the past year, matching the highest rate recorded in 40 years.

So even if this is the inflation rate the Fed needs to target to reverse the inflation cycle, it still calls for a fed funds rate of 6% or more than twice the peak rate shown in policymakers' official rate projections made in March.

Given how tight the labor markets are nowadays and everything else being equal, it would probably take a 6% fed funds rate to impact consumer demand and dampen inflation by creating more unemployment. At the end of March, there were a record 11.5 million job openings against a backdrop of 6 million unemployed. Never before has the Fed faced a significant inflation cycle with labor markets this tight.

Yet, I would bet that long before the fed funds rate gets close to 6%, something else would break to stop the Fed. Things that stopped the Fed in the past were an abrupt and sharp drop in the financial markets or a cessation in the flow of credit that could lead to economic and financial instability.

Given the current market environment, none of those conditions are present, so the risk, for now, is that Fed tightening course could look a lot like those of the past until something else breaks. Investors forewarned.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

Treasury Inflation-Protected Securities (TIPS), which are marketable securities, compensate the investor for inflation by marking up/down the principal of the outstanding security every six months by the six-month CPI inflation/deflation rate. The fixed coupon rate on the originally-issued TIPS is applied to the adjusted principal every six months. If you want to know the full skinny on TIPS, Google treasurydirect.gov. But what I want to discuss is the negative yield on TIPS starting at or about the time of Covid-induced March-April 2020 recession (the red and blue lines in the chart below.) Why have TIPS yields continued to remain negative since the Covid recession? I think the answer lies in the green bars in the chart. Each green bar represents the 24-month dollar change in Fed holdings of TIPS as a percent of the 24-month dollar change in total outstanding TIPS. In the 24 months ended July 2020, the dollar change in Fed holdings of TIPS was greater than the dollar change in total TIPS outstanding, as represented by the green bar being over 100%. The green bars have continued to be above 100% through February 2022. In recent months, the Fed has been “tapering” its purchases of securities, including TIPS. But in the 24 months ended July 2020 through the 24 months ended February 2022, the Fed has been buying all of the TIPS being issued by the Treasury and then some. With a price insensitive purchaser like the Fed buying more than 100% of the new issues of TIPS is it any wonder that the yields on TIPS have been negative? Starting any day now, the Fed is going to turn into a net seller of TIPS. TIPS yields already have moved up close to zero. When the Fed begins to sell them, TIPS yields almost assuredly will rise above zero and rise rapidly. Wonder what will happen to the yield on mortgaged-backed securities when the Fed starts to unload these too?

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.