Tag: On-shoring

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Fed Faces Three Uncomfortable Truths

IMF deputy head Gita Gopinath

IMF deputy head, Gita Gopinath, recently highlighted three uncomfortable truths for monetary policy:

  1. Inflation is taking too long to get back to target.
    Financial conditions may not be tight enough and sustained high inflation could make the task of bringing inflation down more difficult.
  2. Central banks’ price and financial stability objectives conflict.
    Central banks can provide liquidity to struggling banks but are not equipped to deal with problems of insolvency which may be caused by a sharp rise in interest rates.
  3. We face more upside inflation risks.
    The past two decades of low inflation are over and the global economy faces inflationary pressures from:
    • On-shoring of critical supply chains;
    • Rising geopolitical tensions (with Russia, China and Iran);
    • Transition away from coal, oil and gas to low-CO2 energy sources (renewables & nuclear); and
    • Spiraling demand for critical materials needed to meet the above challenges.

Balancing monetary policy is going to be difficult, especially where prices are under pressure from a number of challenges. We expect central banks to tolerate higher inflation for longer in order to preserve financial stability.

Fed only expects to hit 2.0% inflation target in 2025

Fed Chairman Jerome Powell recently highlighted the above conflict between policies to tame inflation and maintain financial stability. During a recent ECB panel discussion, Powell indicated that he only expects the Fed to hit their 2.0% inflation target for core inflation in 2025.

The Fed Chair says job creation and real wage gains are driving real incomes and increased spending. That raises demand which in turn drives the labor market. (WSJ)

Unemployment increased slightly to 3.7% in May but remains near record lows. The tight labor market continues to fuel strong growth in hourly earnings.

Unemployment, Average Hourly Earnings Growth

Tighter monetary policy would drive up unemployment — as demand slackens and layoffs increase — and dampen inflationary pressures. But at the risk of financial instability.

Conclusion

Further monetary tightening is necessary in order to increase the slack in labor markets, weaken demand, and curb inflation in the short-term. But the required policy steps — rate hikes and QT — are likely to crash the economy.

Rather than create financial stability through vigorous monetary tightening, the Fed is likely to tolerate higher levels of inflation — above their 2.0% target — for a longer period.

A less-hawkish stance from the Fed would be bullish for Gold.

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Inflation is baked into the cake

Inflation is a hot topic at the moment. For good reason: higher inflation would drive up interest rates, affecting both bond and equity prices, as well as commodities and precious metals.

March CPI jumped to 2.64% but the increase is partly attributable to the low base from March 2020. Core CPI (excluding food and energy) came in at a more modest 1.65%. The main difference between CPI and core CPI is rising energy and food costs.

CPI & Core CPI

The annual inflation rate in the US ……is the highest reading since August of 2018 with main upward pressure coming from energy (13.2% vs 3.7% in February), namely gasoline (22.5% vs 1.6%), electricity (2.5% vs 2.3%) and utility gas service (9.8% vs 6.7%). Prices also accelerated for used cars and trucks (9.4% vs 9.3%), shelter (1.7% vs 1.5%) and new vehicles (1.5% vs 1.2%) while inflation slowed for medical care services (2.7% vs 3%) and food (3.5% vs 3.6%). Cost of apparel continued to fall (-2.5% vs -3.6%)……..a jump in commodities and material costs, coupled with supply constraints, are pushing producer prices up and some companies are passing those costs to clients. (Reuters)

10-year Treasury yields eased to 1.62% with the breakeven inflation rate at 2.33% — weakening the real 10-year yield to -0.71%.

10-Year Treasury Yield & Breakeven Inflation Rate

Inflation and the Money Supply

Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

CPI & M2 Money Supply

But experience since the 1980s shows several surges in money supply growth without a corresponding rise in inflation. While an increase in money supply may be a prerequisite for a spike in inflation, it is not the cause.

More direct causes of inflation are increases in input costs for suppliers of goods and services. The two largest input costs are commodities and wages. Rises in commodity prices will mostly affect the manufacturing sector, while increases in wage rates impacts on all employers. Also, commodity prices tend to be cyclical, so price fluctuations will be more readily absorbed, while wage increases tend to be permanent and more likely to be passed on to customers.

The chart below shows a much closer correlation between hourly wage rates and CPI since the 1970s, with surges in hourly earnings accompanied by a rise in inflation.

CPI & Hourly Manufacturing Wages

Conclusion

Rising commodity prices are driving higher inflation at present. While some of the pressures may be transitory, due to supply interruptions, underinvestment in new production over the last decade is likely to act as a supply constraint for both energy and base metals. Rising demand fueled by short-term stimulus and longer-term infrastructure investment would act as an accelerant.

Wage rate increases are so far restrained, but that is likely to change as the economy recovers, boosted by decoupling from China and on-shoring of critical supply chains. Shortages of skilled labor are expected to drive up wage rates, maintaining upward pressure on inflation in the longer-term. Training and education of suitable staff will take time.

We have all the ingredients for an inflation spike. A massive boost in the money supply, accompanied by record stimulus payments, much of which has been channeled into savings. This will help to fuel increased demand in the longer term, while restricted supply will drive up commodity prices and wage rates for skilled labor.

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