Inflation is High, but Investors Shouldn't Overreact

CPI data this morning confirmed what anybody who pays rent or buys food already knew (in other words, just about everybody): Inflation is still with us. Prices rose by 0.6% on a month-to-month basis, with annual inflation running at 7.5%. The Fed’s preferred data point, annual core inflation, which excludes typically volatile food and energy prices, grew 6% on a similar 0.6% monthly gain. Those are the highest reads on those numbers since 1982, which seems to confirm the market’s fears that inflation is out of control. In fact, what the market is scared of is not that in itself, but rather what the Fed intends to do about it.

That is a different thing, and the outlook there may not be as bad as this morning’s BLS report indicates.

It is popular right now to bash the Fed, saying that they obviously don’t know what they are doing, and that they should have acted months ago. That is particularly common among people who, hypocritically, just a couple of years ago, were begging the same institution to keep rates low and add liquidity to rescue the stock market. In many cases, the reaction from talking heads has more to do with which political party the President belongs to, rather than any consistent view on monetary or fiscal policy. If you weren’t concerned about massive government spending, ballooning debt, and loose monetary policy three years ago, then your complaints now ring hollow. Similarly, if Trump’s deficit spending upset you, you can’t be happy with Biden pushing to add fuel to an economy that is burning hot.

But let's ignore the politics, because things will become clearer.

Namely, the big one is that Jay Powell saying that inflation was “transitory” was a mistake. It is not that he was wrong; history tells us that inflation always is transitory. The question is how long that transition is. In using that word without allowing for the fact that the transition could take years rather than weeks or month, Powell was setting himself up to be attacked.

Still, the fact is that there really are transitory elements to this bout of inflation. We have had two years of a pandemic that has periodically shut down or slowed output of almost every raw material, manufactured and finished goods, just as demand was recovering from a shock. Whatever monetary and fiscal policy was in place, Economics 101 tells us that when restricted supply meets rising demand, prices will rise. Relatively low vaccination rates that have allowed variants to take hold have kept those conditions in place and those things are not controlled by Jay Powell.

You might say that even if it isn’t their fault, they should have done something about it but, in reality, the Fed has not just stood by and watched as inflation has roared. M2 growth has slowed significantly over the last year, as the chart below shows:

The argument now, though is that they didn’t do enough. With hindsight, should they have instituted a couple of 25 basis point rate hikes or hastened the ending of asset purchases? Sure, but let’s not forget that a year ago, unemployment was at 6.4%, versus a 3.5% pre-pandemic print. If they had hiked rates when unemployment was nearly double “normal” levels, I’m pretty sure that the same people who are apoplectic now would have been apoplectic then. There's simply no scenario in which Powell's critics would have been happy with any decision he had made, regardless of what it was.

What we do know for sure is that this Fed won’t rush into things. That may well have contributed to where inflation is now, even if it didn’t cause it, but it also makes it likely that the most hawkish forecasts for what they will do this year are off the mark. There is now talk of seven or so hikes this year, and the market is pricing in a more than 50% probability of a 50 basis point rise in the first of those. 

Markets don’t exist in a vacuum, so the stock market will also be pricing in those possibilities at current levels. That doesn’t mean we can’t go lower before we move higher, of course. After all, those talking heads will still be laying blame and predicting doom and gloom, and this morning’s data seemed to suggest that they may have a point.

However, as cooler heads take over, the realization will dawn that nothing much has changed and that the Fed will probably be just as cautious once they reverse policy as they have been about making the reversal. We are already seeing that view take hold this morning as index futures have gained back almost all their post-data losses, and a similar pattern of overreaction to bad news followed by a recovery is likely to be repeated several times over the next few months.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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