For the last twelve years, borrowers and financial markets have enjoyed the benefits of record low interest rates. Moreover, official measures of inflation have remained tame, confounding economists who assumed the explosive growth of money supply created by the U.S. Federal Reserve’s “quantitative easing” (QE) policies would surely lead to higher prices. They did, but were mostly limited to asset prices, much to the joy of stock, bond, and real estate investors.
The Fed has engaged in a classic case of hubris. Hubris is often characterized by the phrase “pride goeth before a fall,” or an excessive or dangerous overconfidence combined with the arrogant inability to see the possibility of failure. They have dared to suppress the 4000-year-old bedrock of finance, interest rates, with the conceited belief that they can bend the markets to their will. Yes, they have succeeded in this for a period of time, but we now believe that inflation is about to force the Fed’s hand.
The Fed has stubbornly maintained that rising rates of inflation are “transitory,” and will trend back to modest levels again once the forces of supply and demand come back into equilibrium.
Investors, who earlier in the year were spooked by the specter of higher inflation, now appear to have bought into the Fed’s transitory narrative. Bond yields, which had moved markedly higher earlier this year, have recently been falling. From a March high of almost 2.5%, the yield on the 30-year Treasury bond has fallen to a recent low of 1.8%. Hardly the reaction you would expect from a market fearful of broad-based inflation. But there are several key elements to the inflation question that argue for more persistent price increases ahead.
First is the composition of the inflation index. About 40% of the consumer price index (CPI) is comprised of housing costs. But rather than use actual home prices, the Bureau of Labor Statistics (BLS) in 1983 came up with the concept of “owner’s equivalent rent” (OER) as a substitute, which cynics point to as a way to understate the CPI. You can see the effect in the alternative CPI measures produced by ShadowStats (www.shadowstats.com). They present an alternative CPI calculation based on the 1980 methodology, before OER’s influences, and the difference is startling. The 1980-based CPI calculation is equal to about 13% today, underscoring the effect that fiddling with the CPI has had over the years. Perhaps the cynics are right.
The large increase in home prices and apartment rents are going to feed into OER imminently, leading to a large increase in already increasing official inflation readings. The CPI will not be able to evade the effects of the real estate boom for much longer. Moreover, rents and home prices are sticky, meaning they tend to go up easily, but only very grudgingly go down. Thus OER will be making it less likely that inflation is transitory.
Second, inflationary psychology is starting to take hold among consumers and businesses. This is a key piece to whether inflation persists. Human behavior is very difficult to change, and once a belief system takes hold it may be in place for years. An important reason inflation had been persistently low over the past three decades is that everyone believed it would be controlled at a low level, thanks to the efforts by Fed chairman Paul Volcker to successfully “break the back” of inflation in 1981.
Rising inflation can create a cycle of inflationary expectations, and so change behavior. For example, suppliers who must now charge more for raw materials lead manufacturers to raise prices to their end customers. Those customers, in turn, start to demand compensation in the form of higher wages to offset the cost of living. We are seeing inflationary psychology taking hold at each of these levels currently, with no obvious end in sight.
Third, inflation is also occurring in subtle ways that escape the headlines, but are nonetheless reductions in purchasing power. Primary among these is “shrinkflation,” the growing tendency among manufacturers to reduce the quantity of a product while still charging the same price. This is in effect another form of inflation, since the per unit price of goods increases when products shrink. Shrinkflation is somewhat insidious, since most consumers do not think in cost per unit, but overall cost. Boxed cereals, tortilla and potato chips, and, yes, Costco paper towels have all been downsized over the years. Shrinkflation is a subtle process, but we have seen more of it in the past year, and especially the first half of 2021, as businesses scramble to offset increasing costs of production.
A corollary kind of inflation comes from the decline in quality of many goods, especially household appliances. We are paying the same price, or more, for products that don’t last as long as they did 20 years ago. The BLS has conjured up a concept for increasing quality called “hedonic adjustment.” The premise behind hedonic adjustment is that if consumers are getting more for their money, due to, say, technological improvements, that should count as a decrease in price, and thus lowers inflation. But there is no corresponding adjustment for declines in quality, where consumers are getting less for their money because a product wore out quickly. Anyone whose dishwasher broke after one year probably feels they paid too much for the quality they got.
Finally, Fed policy has made the generation of income from investments much more difficult as yields have been held near zero percent for a dozen years. This has created a phenomenal inflation in the cost of retirement. In the good old days (pre-2008) a retiree with $1 million could buy 30-year Treasury bonds yielding 5%, netting an annual income of $50,000 from the portfolio. Today, T-Bonds yield only 1.8%, meaning a retiree would have to have $2.78 million in assets to generate the same $50,000 of income—a 178% increase in principal required. Hardly a tame measure of inflation when looked at this way.
The Fed’s hubris arises from their belief that they can hold back the forces of the market, much like characters in Greek mythology who dared to challenge the gods. We have had the luxury of complacency about inflation since the mid-1990s, as understatement in the CPI calculation, globalization’s downward pressure on prices and raw materials costs, muted wage inflation and “disinflationary” psychology have led to a belief that inflation was forever dead.
Market forces of inflation, though, are lining up to force the Fed’s hand, and investors can no longer take artificially low interest rates for granted. The Fed has tried to suppress interest rates from money markets to 30-year bonds, and bond investors have meekly acquiesced. Should the bond market wake up and take matters into its own hands, the Fed may lose control of monetary policy, and we may indeed suffer the wrath of the financial gods.
Market investors may not be waiting for the Fed to act in reaction to inflation, however. While financial news headlines focus on the “meme” stocks that are daily kicked around like footballs by day traders, recent stock behavior for the broad market has become decidedly less bubbly.
Two key stock indicators have turned bearish in July. The NYSE advance/decline (A/D) line has turned down and given a sell signal. The A/D line cumulates the daily difference between the number of stocks advancing versus declining. Thus, in a bull market, more stocks go up in price and the A/D line rises, while the converse is true in a bearish market. The current sell in the A/D line doesn’t mean a bear market is imminent, but rather that selling is starting to overwhelm buying. If this continues long enough, then yes, downward trends will become more entrenched, and some sort of correction or bear market will be the result.
Our old friend, the NYSE Bullish %, has also moved to a bearish sell signal (below). This measure, compiled by Investors Intelligence (www.InvestorsIntelligence.com) tallies the percentage of stocks in a given index, in this case the NYSE, that are on buy signals, based on the point & figure (p&f) method of charting. P&f charts have the advantage of unambiguous buy and sell signals, making it easy to calculate the proportion on buys. Like the A/D line, it is a measure of breadth, and the message is similar: selling is beginning to overwhelm buying.
The NYSE Bullish % signal is being confirmed by similar bearish formations in the bullish %s for the S&P 500 and the small- and mid-cap indexes, lending credence to the idea a broader correction may be developing.
How far it may go is anyone’s guess, but the combination of hotter inflation readings, potentially higher interest rates, and deteriorating breadth imply that investors would do well to have some “dry powder” (i.e. cash) on hand.
In the recent past, every time broad indicators such as the A/D line have warned of a correction, the Fed has stepped in with more money printing via its QE policy. With inflation readings at multi-decade highs, can they afford to do so without spooking the markets? We don’t believe so, as additional rounds of QE may now be seen to feed inflation, not just prop up asset prices. The Fed is facing a moment of truth when they have to bow to the reality of inflation and put their hubris aside while they still have some shreds of inflation-fighting credentials left.