This is why the market should be ready for aggressive policy changes from the FOMC this year.
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June 15, 2021
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This story originally appeared on MarketBeat
This is why the Fed will increase the rates this year
While the COVID-19 pandemic has been the defining Black Swan event of our generation, rising inflation is the White Swan event that will dominate our lives for the foreseeable future. The White Swan events, events which are easily predictable and easy to avoid but for some reason no one seems to be doing anything about it and in this case the prices are going up. The FOMC has tried to make sure that hyperinflation is transient but we disagree. The evidence does not suggest that recent consumer price spikes are transient and will lead the FOMC to raise interest rates this year. The real question for investors is whether or not to prepare for such an event and we believe the answer is yes. If you think about it, the FOMC begged the economy to start raising prices for years and it finally started to listen.
Inflation is already here and you can’t get away from it
The really scary thing about the picture of inflation is that inflation is already there and nobody is doing anything about it. Starting with the Fed’s preferred measure of core inflation at the consumer level, the PCE price deflator, inflation exceeded the FOMC’s 2% target in March and only moved up accelerate since. The PCE accelerated from the baseline of 1.9% in March to 3.1% in April and we expected an increase in May and June. Not a single company in the S&P 500 has talked about lowering prices, otherwise they are talking about impact of higher input costs, higher labor costs and higher raw material costs, and the need to increase their prices to offset these pressures.
The consumer price index tells the same story. The Consumer Price Index has beaten expectations over the past 2 months and accelerated from April to May with YOY gains of 5.0%. That’s more than double the Fed’s 2% target rate and it’s picking up steam. Now, if we were talking about GDP growth or earnings growth, the hot numbers wouldn’t be that important. Last year GDP shrank by 30% and profits fell by a double-digit rate for most companies, making this year’s comps incredibly good. That said, the economy and corporate profits have barely returned to pre-pandemic growth levels. Inflation did not contract last year. It slowed down to about 0.5%, then it accelerated again and it’s still accelerating. If there has ever been a time for the Fed to act to curb inflation, we think it is.
Core inflation data does not measure real inflation
While inflation is the net result of rising consumer prices, our basic consumer inflation data does not measure what it is meant to measure. The two most influential items on consumer spending are energy and food. These are the first two things taken out of the equation. When included, the impact of the index often matches reality. We know from the signs on the street and the prices we pay that gas prices are almost double what they were last year. This is a 100% increase in energy inflation that is not measured correctly and this cost is passed on to food prices.
The biggest cost for food producers is energy, when it costs them more to buy gas it will cost us more to buy food and this goes for so many other sectors of the world. ‘economy. According to the CPI, the cost of housing has only increased by 2.2% in the past year, but we know that the price of lumber, building materials and houses has increased by at least 20% year-on-year and that’s a very generous estimate. Home prices have increased by at least 20% according to the Case-Shiller report and lumber prices have increased by triple digits. In our opinion, real consumer inflation is already at double-digit rates.
The Fed knows more than it suggests
One would have to be naive enough to believe that the FOMC does not know more than it suggests. We think this is evident in the sudden change in position that we have seen in the committee over the past six months. At the start of the year, even until March, the FOMC predicted at least two years of zero interest rate policy, no need to type, no need for interest rate hikes. Now, 6 months later, the group of them are babbling about ‘talking about talking about tapering’, with their friend, Treasury Secretary Janet Yellen (Cough coughs the x-FOMC leader), who thinks a rate hike may be necessary. The questions for us on the June FOMC meeting are not whether they will change what they say in the statement, but what do they change and how will that change? affect the market. In our view, the market must be prepared to embark on a path of gradual reduction and higher rates.
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