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Wealth Matters Newsletter - April 2021
The Return of Inflation (Expectations)?Written by: Mark P. Bernier, CFA, Senior Vice President/Wealth Management Officer
Discussions about inflation are often reminiscent, invoking memories of the 1970s and 1980s. The inflationary environment of the 1970s/early 1980s was snuffed out by aggressive policy actions by the Federal Reserve, and then Fed Chairman Paul Volcker. Those policy actions and resulting interest rate environment are still remembered as the stuff of legend. Double-digit rates of interest being earned or paid on deposit products, mortgages, and almost every other type of credit vehicle are almost fondly remembered in many conversations I’ve had with clients over the course of my career. Comments like, “I remember when I was earning 12% on my CDs…” or “I paid 14% interest on my first mortgage…” are common during those conversations. The painful economic environments before and immediately after those monetary policy initiatives are often ignored in those conversations, however. As a reminder, the year-over-year change in the Consumer Price Index (CPI) - a frequently referenced measure of inflation - from January 1979 to January 1980 was 13.9%. Why was the subject of inflation so popular with economists and market strategists during the first quarter of 2021, when the year-over-year increase in CPI was still below 2%? It is all about expectations.
The fiscal and monetary policy responses to the pandemic have been well-covered. Stimulus checks, Paycheck Protection Program (PPP) loans, zero interest rate policy, and quantitative easing have all contributed to enormous growth in money supply in the U.S. and subsequent growth in balances in bank deposits nationwide. The chart below from the Federal Reserve Bank of St. Louis illustrates this growth in bank deposits.
Since U.S. economic growth is largely dependent upon consumer spending, large reserves as illustrated above may indicate future spending capacity. Subsequently, economists and investors view this capacity as potentially inflationary. If the economy continues to improve and we do not experience any material pandemic-related setbacks, improved consumer sentiment and confidence may result in additional spending, releasing savings into the economy, and the supply of money gaining velocity in the economy. It has been the lack of velocity that has largely kept inflation in-check since the massive expansion in money supply that resulted from these stimulus measures over the last year. To reiterate, current concerns about inflation are based on potential. It remains to be seen if consumers actually draw down savings.
Another source of heightened inflation expectations stem from Federal Reserve’s stance on combatting inflation. As you may recall from previous versions of this newsletter, the Fed has two objectives: reasonable price stability and maximum employment. There is little question that the Fed has deployed an arsenal of monetary policy weapons in the fight to get the economy back on solid ground, but a change in how or when the Fed decides to unwind these accommodations has changed substantially. The Fed had previously taken a proactive approach to fighting inflation by raising interest rates or reducing other accommodations when economic conditions presented the risk of inflation. In other words, the Fed would try to prevent inflation from running above its long-term target of 2.00%. The Fed has adopted a new framework for monetary policy guidance, one that is in fact reactive. Under this new framework, the Fed has stated that monetary policy will remain accommodative as long as needed to hit its targets. The following is an excerpt from the statement issued by Federal Open Market Committee at the conclusion of its two-day meeting on March 16-17, 2021:
The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. With inflation running persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer term inflation expectations remain well anchored at 2 percent. The Committee expects to maintain an accommodative stance of monetary policy until these outcomes are achieved.
This is new policy territory for the Fed and has added to inflation expectations, perhaps because investors and economists are cautious on the Fed’s ability to exhibit that level of control over inflation.
How have markets responded to elevated inflation expectations? Though the S&P 500 is hitting new highs as of this writing, the bond market, particularly U.S. Treasuries, has not fared as well. The yield to maturity on the 10-year U.S. Treasury Bond has risen from 0.91% on December 31, 2020 to 1.73% at the close of business on March 30, 2021. See the chart below from S&P Global.
10-Year U.S. Treasury Bond Yield to Maturity
Your first inclination might be to celebrate, as higher interest rates mean higher interest earnings, and higher interest rates could be a signal of the economy improving. Those two statements are true, but the speed of this move higher has caused investors to pause. Interest rates moving higher from the extreme low levels of 2020 was expected, but to see the yield to maturity on the 10-year Treasury, a benchmark for many asset and loan prices, nearly double in three months has investors questioning whether or not the Fed can exhibit the control over rates and inflation that seek to impart.
Stocks have not been immune to the move in rates, as large technology company stocks have seen the most selling pressure this quarter. High valuations exhibited by many of these stocks have been hampered by the rise in rates. Investors and professional analysts will assess the value of a stock based on expected future earnings or cash flows, and discount those future estimated earnings or cash flows by a rate of interest. Low interest rates are a benefit to stock prices; higher rates of interest are an impediment for stock prices. We still anticipate the stock market doing well in 2021, but investors will likely favor more cyclical or economically-sensitive companies.
We anticipate seeing some inflation in the months ahead, if only due to prices falling so dramatically during the second quarter of 2020. What remains to be seen is if that inflation is temporary, or if the pace of economic recovery and consumer behavior turns the temporary into a going concern. Stay tuned!
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