Will recent monetary policy bring unintended inflationary consequences?
The United States confirmed the first case of Covid-19 in January of 2020. The following year would prove to be one of the most challenging periods in American history. The U.S. economy contracted by 31.4% in the second quarter of 2020 at the low point of the shutdown as unemployment surged. As the country entered a recession, we witnessed countless businesses close as containment measures were put into place by state and geographical area. Unprecedented fiscal and monetary policies were rolled out to combat the economic shutdown, but will there be unintended inflationary consequences?
Throughout March and April of 2020, the U.S. government passed three main relief packages and one supplemental package that totaled $2.8 trillion. After the election of President Joe Biden in November of 2020, an additional $900 billion stimulus bill was passed. Finally, a fifth major stimulus package was signed into law in March of 2021 which was known as the $1.9 trillion American Rescue Plan.
The first relief package was known as the Coronavirus Preparedness and Response Supplemental Appropriations Act. This package was signed into law in March of 2020 by then President Donald Trump and allocated $8.3 billion to fund research for a vaccine, gave money to state and local governments and allocated money to help with efforts to stop the spread of the virus.
The second package, the Families First Coronavirus Response Act (FFCRA) allocated $3.4 billion to provide money to families who rely on free school lunches, mandated that companies with 500 or fewer employees provide sick leave, provided $1 billion for additional unemployment insurance and funding to make Covid-19 tests free. Also, during this timeframe, the Federal Housing Administration (FHA) and Federal Housing Finance Agency (FHFA) implemented foreclosure and eviction moratoriums.
The third package—and by far the largest —known as the Coronavirus Aid, Relief, and Economic Security Act (CARES), appropriated $2.3 trillion for many different efforts. These efforts included a one-time $1,200 direct cash payment to citizens, expanded unemployment benefits, additional unemployment payments per week, waived early 401k withdrawal penalties, mortgage forbearance and moratorium, $500 billion in government lending to companies, $367 billion in loans and grants as part of the Paycheck Protection Program (PPP), $130 billion to hospitals, $150 billion in grants to state and local governments, and $60 billion for schools and universities.
The fourth stimulus package was passed in December of 2020 and consisted of $900 billion in relief. This package included another direct payment of $600 to citizens, additional expansions to unemployment assistance, $325 billion in additional small business loans, moratorium extensions, $45 billion for transportation, $69 billion for public health measures, $82 billion in education funding, $25 billion in emergency rent assistance and $26 billion in nutrition and agriculture.
Finally, this brings us to the fifth relief package named the American Rescue Plan Act of 2021 which went into effect in March of 2021. This plan included another $1,400 direct payment to citizens, increased Child Tax Credits, further unemployment insurance expansion, $130 billion for K-12 schools, $55 billion for vaccine distribution, $39 billion for higher education, $30 billion for public transit, $25 billion in emergency rental assistance, $25 billion for Small Business Administration grants, $40 billion for child care, $15 billion for airlines, additional PPP assistance, and provisions for student loan forgiveness.
On the monetary policy side, extreme measures were taken by the U.S. Federal Reserve to stem the economic downturn. The Fed’s stimulus measures fall into three categories: interest rate cuts, loan and asset purchases and regulatory changes. All of these efforts were deployed during the downturn to ensure the U.S. would not suffer a liquidity crisis.
During the start of the pandemic and economic shutdown, the Federal Reserve acted by lowering interest rates. The Fed cut its’ benchmark Federal Funds borrowing rate twice during March of 2020. This effectively lowered the U.S. overnight borrowing rate to a range of 0.00% to 0.25%. This was the first time that interest rates were cut by the Federal Reserve since the Great Recession in 2008. The Fed explained that easing conditions were necessary to combat the massive disruption in economic supply and demand. By lowering borrowing rates, the Fed hoped to create an environment of easy borrowing conditions to coincide with a rebound in activity that would inevitably come once the pandemic was behind us.
The Federal Reserve also reignited a program that was implemented during the Great Recession, Quantitative Easing. The Fed announced in March of 2020 that they would begin purchasing at least $500 billion in U.S. Treasuries and $200 billion in Mortgage-Backed Securities in an attempt to increase market liquidity. The Fed declared that the program would be open ended and that it would continue to purchase securities in the amounts needed to support smooth functioning markets. Since then, the Fed has tapered these purchases down to $80 billion a month in Treasuries and $40 billion a month in MBS Securities. In the 2020, the Federal Reserve’s balance sheet grew from $3.9 trillion to $6.6 trillion. The Fed also expanded its’ repo operations in March of 2020 by $1.5 trillion and added another $500 billion later that month. These repo operations effectively allowed the Fed to loan money to banks by purchasing Treasuries from them and selling them back to the banks at a later date.
In terms of ongoing regulatory changes, the Federal Reserve announced a number of initiatives to add further liquidity to financial markets. In December of 2020, the Fed announced that it would continue quantitative easing purchases until further substantial progress has been made toward their dual mandate of inflation and unemployment. The Fed expected this to take several years, however our latest reading of inflation and unemployment are both well above where the Fed thought they would be at this point. Additionally, in March of this year the Federal Reserve announced that it was relaxing its’ policy regarding bank reserve requirements and restrictions on dividends & buybacks. These moves eased requirements for the largest banks in the country to meet regulatory capital requirements and enable an easier lending environment.
Setting the Stage
The stimulus measures, monetary and fiscal, have helped buoy the economy and financial markets. However, these measures do not come without risks; the economy overheating and a resurgence of inflation among them. The Federal Reserve has acknowledged these risks and stands ready to act albeit with a new framework. In addition to the aforementioned measures, the Fed has altered their policy to now average out inflation, allowing it to run above their 2% target for a sustained duration. Their emphasis on employment has become more granular as they are now breaking it out by demographics. The efforts to keep rates accommodative are intended support interest sensitive spending and ensure the economy has a full recovery. With the lowest earners lagging the recovery seen in white collar jobs, the Fed wants to ensure the recovery doesn’t leave them behind. They see the risk of acting preemptively to stave off inflation at the expense of the lowest earners as too high and have adjusted their framework in response.
There are a few considerations omnipresent in the mind of economists when looking at inflation data. The first is the so-called base effect: prices dropped sharply in March 2020 with demand collapsing for many goods and services as businesses closed and consumers sheltered in place. Base effects will wane as summer progresses. Another caveat the Fed points to is the supply chain issues which have caused broad price pressures. They expect these pressures to be transitory as they are a function of Covid-related bottlenecks coupled with business decisions that resulted in a reduction of capacity for manufacturers. The semiconductor industry is a prime example; companies reduced input orders and capacity as they anticipated weak consumer demand that is typical of recessions. However, thanks to the support from the Fed and the White House retail demand has snapped back to new highs (see Figure 1).
The requisite lead time for semiconductor companies to increase manufacturing capacity is approximately one year. The bottlenecks in this industry have bled through to a plethora of products as semiconductors are a basic component in modern electronics. The Fed sees this as well as bottlenecks in other industries and the associated price pressures as transitory. The problem has been recognized and the White House has established a supply-chain disruption task force. Given that backdrop, let’s look at a few key inflation inputs.
To economists and central bankers, commodities do not garner too much attention as they make up a relatively small part of consumer inflation and are often volatile. However, the magnitude of the moves we have seen has some concerned. Lumber, iron ore and copper have all hit record highs. Corn, soybeans, and wheat have hit their highest level in eight years and oil recently hit a two-year high. An increase in one of these inputs is often dismissed as they are used to make goods which in aggregate make up only 20% of the weighting of U.S. Consumer Price Index (CPI). Nonetheless, the broad increase in commodity prices are being felt by producers. Figure 2, the Producer Price Index (PPI) for China, shows factory-gate inflation at its highest level since 2008.
Manufacturers must either absorb these costs at the expense of their margins or pass these increases downstream in the form of higher prices. Rising producer costs coupled with strong export demand may give Chinese manufacturers more latitude to increase prices. However, a recent study by the St. Louis Fed found a low correlation between costs of industrial materials and prices for durable goods. This suggests the commodity price shocks on inflation have become less pronounced as branding and other elements have become a bigger factor in pricing. The magnitude and breadth of the moves we are seeing in commodity prices may defy this study. Also, many expect the price pressures on commodities to ease as U.S. consumer spending shifts to services which are less commodity intensive and make up a bigger portion of the inflation data. As business operations normalize, service-based prices will be highly scrutinized.
The red-hot housing market has been a bright spot since shortly after the onset of the pandemic. Housing is considered an investment good and not a consumable good. However, CPI does attempt to reflect housing in the data through owners’ equivalent rent which is reported by consumers as the price that they would be able to rent their house for monthly.
In the wake of a 2% increase in owners’ equivalent rent in April from a year earlier, Bloomberg columnist Brian Chappatta took a deeper dive into this subset. He compares it to the housing market, where single-family homes rose 16.2% Q1 2021 over Q1 2020 according to the National Association of Realtors. The divergence between the two can be seen in Figure 3. This is not a new phenomenon as is evidenced in the chart below; but with owners’ equivalent rent making up a quarter of CPI according to the Labor Department, this input should garner attention as we sift through the coming inflation data as this may prove to be understating housing related inflation.
Given the slack in the labor market, with the U.S. labor market 7.6 million jobs short of pre-pandemic levels, many policy makers had not anticipated much wage inflation. The ample pool of workers in theory would lend to muted wage gains. However, for a second straight month, average hourly wages far surpassed economists’ estimates (Figure 4). The record number of job openings, 9.3 million in April, coupled with a record number of people quitting their jobs, 4 million in April, have made it difficult for employers to fill jobs. A record of 48% of small businesses said they could not fill jobs in April.
Generous unemployment benefits, lack of childcare options, early retirements, and lingering fear of Covid-19 are cited as the main drivers as to why people are not entering the workforce and why many are leaving it. This environment, coupled with surging demand, has employers scrambling to hire. In turn, they are raising wages, especially in the leisure and hospitality sector. The average hourly wage in this industry was $18.09 in May, up from $17.86 in April. Over the past three months, wages in this subset have risen at an annualized pace of 14.5%. Employers have taken different approaches to increasing pay; many are offering one-time signing bonuses while others are increasing base pay, and some are doing both. One-time payments are included in the above data, so there is a chance that wage pressures will subside as these one-time payments fall out of the data. However, those who see a more structural shift are raising wages which will likely stick around due to the theory of wage rigidity—the difficulties companies face trying to reduce wages.
Wage inflation raises the prospect of wage-price spiral, a feared concept in economics, which is a macroeconomic theory explaining the cause-and-effect relationship between rising wages and prices. In short, wage increases put pressure on the margins which businesses pass along to the consumer in the form of higher prices for goods: workers then demand higher pay to stay ahead of an increased cost of living. This is a delicate balance for the Fed and White House as they want to see wage growth in the lower-paid services industry, but inflation is regressive in nature as it has a disproportionately negative affect on the lowest earners. As schools open, Covid subsides, pent up demand is spent, and unemployment benefits expire, we may see wage inflation subside; only time will tell.
The CPI data released June 10th surged 5% to the highest annual inflation rate since 2008. The core-price index, which excludes the volatile food and energy subset, rose 3.8% in May year over year—the largest increase since 1992. Prices for used cars and trucks jumped 7.3%, which accounted for roughly one-third of the rise in the overall index. Semiconductor related bottlenecks have crimped new car production which in turn has bolstered prices for both new and used vehicles. The base effects are important to keep in mind when looking into the year over year figures as this distortion creates and artificial shock to the upside.
However, on a month-to-month basis, CPI rose to a seasonally adjusted 0.6% and core prices rose 0.7%, both of which beat analyst estimates and suggests there is inflation outside the base effect distortions. The latest gains were broad and driven by growth in the cost for household furnishings, airfare and apparel. The increased costs in food and labor, coupled with reopening, have many economists projecting service-related inflation to be the main driver in the near-term. They anticipate the restaurant and hospitality sectors will look to pass their increased costs on to consumers rearing to spend thanks to record-high savings and stimulus. The bond market seems to buy into the transitory theory as the yield on the 10-year Treasury sunk to a 1.46% after May CPI data bested estimates. It is important to note that while the Fed’s preferred inflation measure is the Personal Consumption Expenditures (PCE), they nor the bond market overlook CPI data.
As the inflation debate heats up and base effects wear off, keep in mind that the projections by the Fed and other economists are educated guesses. The amount of time, information and modeling that is put into these projections is immense but a guess, nonetheless. The pandemic and the subsequent fiscal and monetary stimuli are all unprecedented and only time will tell if this will materialize into sustained, higher inflation.
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Nick Meletio and Tucker Brown