Investors Start to Worry About the Fed

The stage is set for the second half of 2021 to deliver a strong, broad economic expansion, probably the best in a long time.

There’s a strong foundation for sustained growth. Households improved their balance sheets during the pandemic, helped by stimulus payments and rising asset prices.

Also, incomes are rising. Households, as a whole, are in their best financial positions since before the financial crisis.Most businesses also are in good shape. Many report that their biggest problems are finding enough employees and products to meet demand.

They have plans for additional capital investments to expand capacity.Rising inflation is a result of this strong growth.

Federal Reserve officials maintain that most of the price increases are temporary. They don’t anticipate raising interest rates until 2023 or later and are taking only modest steps to curtail the Fed’s massive stimulus measures.Some rising prices are indeed caused by temporary factors. Prices will stop rising and probably decline after normal market adjustments balance demand and supply. Lumber and copper prices already declined substantially.

But some broad pressures on prices are likely to continue.

The inflation measures from all the surveys of businesses are at their high-est levels in decades, and some measures are at all-time highs. Businesses of all sizes and in all sectors report the strong price pressures and expect them to continue.

Wages and salaries will continue to rise because of the employee imbalance. It is noteworthy that labor force participation among those 55 and older hasn’t increased as the economy recovered.

The details of the monthly Consumer Price Index (CPI) report also are revealing. The headline CPI number remained low for decades. During that time, services sector inflation was high and sustained. But prices for goods and commodities declined, offsetting the services sector inflation enough to keep the headline CPI low.In the latest reports, however, price increases have been widespread.

Several secular forces kept inflation in check for decades, but most of those forces now are fading.

Key secular forces that kept a lid on prices included tight money policies and inflation targeting by central banks, a rapid increase in globalization and global trade, and government policies favoring business and capital over labor.

The major secular deflationary force still in place is technology leading to higher productivity. Even that is threatened by increased regulations and taxes around the globe.Another deflationary trend still in place is the velocity of money.

It is extremely low but recently began climbing.The biggest risk to investors is that higher inflation might cause the Fed to reduce liquidity faster than currently anticipated.

We had a taste of that after the June 16-17 meeting of the Federal Open Market Committee, when it was reported a couple of Fed officials said interest rates might have to increase before the end of 2023.

The projected interest rate increase was modest and would occur only a little earlier than markets were anticipating.

But stocks declined significantly, and bonds appreciated as interest rates declined. The stocks with the highest returns earlier in the year and that benefit the most from easy monetary policy declined the most and still are down.

Markets tumbled again on July 7 after the minutes from the mid-June meeting were released, reporting that a few committee members said economic growth was faster than expected and causing too much inflation.

These were very meek indications of tighter monetary policy down the road, but they roiled the markets.I expect the central bank will avoid tightening policy prematurely. It will wait for the markets to indicate that inflation is too high.

Key market indicators will be rising prices for gold and other inflation hedges, higher long-term interest rates and higher break-even inflation rates. The Fed won’t do anything to cur–tail economic growth before inflation becomes painful.

It could take markets a while to figure that out, but when they do the trends of earlier this year will resume.