The June 16 Federal Open Market Committee (FOMC) meeting Q&A session with Chairman Jay Powell and recent comments from The Fed have signaled two potential inflation rate hikes in 2023. Two days later, James Bullard, president of the Federal Reserve Bank of St. Louis, signaled there could be a rate hike as soon as 2022. With these mixed signals and upcoming FOMC meetings, how might inflation and the markets play out in 2021?
Inflation and the Dollar
One explanation for inflation is that there are too many dollars chasing too few goods – or more simply put, things will cost more over time. Say you can purchase a pair of shoes for $100. Then, inflation is 3 percent over the course of a year, making them cost $103 after one year. This example illustrates when the cost of things – including school, housing, clothes, food, energy, etc. – increases according to the Consumer Price Index or CPI, as the U.S. Bureau of Labor Statistics defines it.
Some Factors Impacting Inflation
One of the Federal Reserve’s dual mandates is price stability. There are three ways The Fed can steer inflation.
The first is by adjusting the Federal Funds Rate, which determines how much banks pay for overnight borrowing from a “depositary institution,” such as the Federal Reserve Bank. By raising this rate, it lowers spending and helps reduce the likelihood of inflation by tamping down costs, along with pushing up interest rates for lenders.
Another tool is the Fed increasing its Reserve Requirement. By increasing this metric, it slows down spending, and therefore inflation by how much money institutions can lend out.
The third is through open-market operations (OMO), whereby the Fed can either buy U.S. Treasury Bonds to increase the supply of money or sell U.S. Treasury Bonds to decrease the money supply.
The Fed uses the Personal Consumption Expenditures (PCE) Index from the U.S. Bureau of Economic Analysis, along with the Depart of Labor’s Consumer Price and Producer Price indexes, to gauge inflation.
Understanding Cost-Push Inflation
According to the Federal Reserve Bank of San Francisco, there are a few ways to quantify inflation. Cost-push inflation happens when inputs necessary for manufacturing cost more. This can include input resources that cost more or worker pay that rises quickly. During the energy price spike during the 1970s, the increased cost of fossil fuel increased production and commercial hauling costs.
According to the Monthly Labor Review, the Bureau of Labor Statistics, the Federal Reserve Bulletin and the American Economic Association, wage-push inflation is the “thesis” that argues employee pay has risen faster than actual good or service output and is squeezing profitability and price attractiveness to consumers.
One reason this occurs is due to a minimum wage mandate. Another reason is to attract better workers or increase their applicant pool. It’s important to know that doing so will increase the money supply in the economy, which will help them purchase more and create a higher demand for goods. This will further increase the price of goods, whereby businesses will charge more for goods to pay higher wages, which will increase the price of goods throughout the economy. It’s all about balancing the wage increases versus the cost of goods.
Demand-pull inflation happens when there’s the classic too much demand but too little supply scenario. It’s often accompanied by an increase in money supply by a loose central bank monetary policy, oftentimes leading to higher prices.
Looking to Commodities
Taking energy, specifically West Texas Intermediate Spot price, due to increasing costs of energy, this sector is projected to do well in an inflationary scenario. Looking at data from the U.S. Energy Information Administration, the price per barrel increased from nearly $45 on Jan. 1 to more than $59 on April 9, to more than $71.55 on June 18 and climbing. Be it stocks, options or futures, investors who took positions earlier in 2021 or 2020 likely benefitted from inflation.
Performance May Vary by Asset
However, it’s important to select the right assets to decrease the likelihood of losses and increase the chances of gains. For example, fixed income, in conjunction with higher interest rates, is likely to decline due to not staying competitive with inflation rates. Using the “discounted cash-flow method” to evaluate a stock, especially in periods of higher interest rates, growth stocks fare worse compared to their value counterparts. When investing in dividend paying stocks, these may provide a hedge against inflation because they oftentimes can pass on higher costs for their products, keeping their earnings in line with growth expectations, along with receiving dividends themselves.
While the future of the market can’t be predicted, paying attention to how the economy reopens and the Fed manages inflation can help determine what investments are the best going forward.