On June 10, the U.S. Consumer Price Index printed an alarming 8.6% and sent interest rate futures markets into a chaotic repricing of Federal Reserve expectations. At that time, Fed Fund futures had been pricing in 50-basis point rate hikes at each of the next two Fed meetings. But in the hours that followed the CPI release, estimates changed to two 75-basis point hikes. The highest inflation reading in 40 years has fueled an ongoing debate as to what is causing this and what is the best path forward.
In its most simple terms, inflation is rising prices due to aggregate demand outstripping supply. Monetarists will argue that inflation is always caused by increases in the money supply and that the 40% increase in M2 over the past two years should bear most of the blame. Meanwhile, other analysts will point to issues on the supply side.
“Supply chains take a very long time to heal,” said Cameron Dawson, chief investment officer at NewEdge Wealth. “A small disruption just starts to cascade and has this snowball effect. That’s what we saw during the pandemic and lockdowns and the surge in demand for goods that came out of that.”
Of course, the surge in demand was, at least in part, due to the extraordinary monetary and fiscal policies implemented by the Federal Reserve and the federal government to lessen the pandemic’s negative economic impact.
Despite disagreements on the current causes of inflation, the Federal Reserve has made it clear that their goal is to reduce the demand imbalance through short-end rate hikes and quantitative tightening on the long end. But there are some signs that the supply chain is in the process of healing on its own. Dawson believes that we are starting to see early signs that both goods demand and manufacturing activity are starting to wane, as the New York Empire Fed and Philly Fed both pointed to much slower manufacturing activity, as well as improvement in supplier delivery times.
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“We are also seeing it in the trucking data, where truck demand is starting to fall,” Dawson said. “That’s indicative of some health coming back into supply chains where now there’s not as much scarcity and urgency, so some of the pricing can come out of things like durable goods.”
The issue of skyrocketing energy prices is important in the Fed’s current dilemma. Retail gas prices have doubled since the beginning of the pandemic, and there is a belief that this has been caused by embargoes enacted against Russia in the wake of the Ukrainian conflict. If this is indeed the case, then there is an obvious concern that the Fed’s efforts to lower demand will have little efficacy and that increasing availability of energy supply would be paramount in achieving the elusive “soft landing” that the Fed desires.
“We now have very high energy prices, which restricts capacity,” Dawson said. “Imagine if you are a trucker. Your pricing is going down but your costs are rising because the energy, diesel prices, are going up. That effectively removes capacity from the system.” The Fed itself has mentioned the difficulties of its path forward as Chairman Jerome Powell recently admitted that a recession was definitely possible.
The last element in the inflation debate is in regards to future expectations. As it stands, the market reflects a belief that over the next five years, inflation will average out to under 3% per year. This is according to the current level of five-year breakeven rates. This is significant in that as expectations for long-term inflation rise, it becomes self-fulfilling in anchoring that inflation. Thankfully, this is not the case yet. In the coming weeks, traders and analysts will be closely monitoring both inflation data and Fed rhetoric for any signs of a pivot.
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