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The Fed Still Doesn’t Need to Worry About Inflation

Last update on: Aug 12 2021

Many analysts and investors misunderstand inflation, and that’s caused them to misjudge markets the last few years.

Most people believe that a lot of money printing by the central bank always leads to a lot of inflation. I remember making an investment presentation to a local group a year or so after the financial crisis. A member of the audience insisted that in a year or two inflation would be 5% or higher because of the Fed’s money printing. He believed it had to happen.

But money growth doesn’t always lead to high inflation. There are several factors that affect inflation. High money growth leads to high inflation only when those other factors are constant and in their normal states.

The latest Consumer Price Index and other inflation reports show that inflation over the last few months has been flat or risen only a little. The 12-month inflation rates are below the Fed’s 2% target. This is the case despite years of quantitative easing by the Fed and other central banks and the trillions of dollars of securities on the Fed’s balance sheet.

The central bank actions have pushed inflation higher than it would have been. We might even be in a deflationary environment today if it weren’t for the aggressive monetary policies. But all that printing hasn’t caused high inflation. Inflation hasn’t even reached the post-war average.

Most people focus only on the short-term or cyclical factors. They see economic growth and declining unemployment and believe inflation has to be around the corner. In normal times, that’s a good reading of events.

But other factors also are at work today.

A couple of factors that kept a lid on inflation before the financial crisis still are at work today: globalization and technology.

Globalization means more competition. Manufacturing and labor-intensive industries flow toward countries with lower wages. That keeps the prices of goods down. When trade is relatively free, domestic producers have to compete with overseas producers. Wages in China influence the prices of products in the United States.

Technology can make workers more productive or can replace workers. Either keeps prices low.

The effects of the financial crisis and the debt bubble that preceded it also continue to moderate inflation.

Too much capacity was brought online during the boom. A lot of that capacity still is idle, keeping a lid on prices. While there’s relatively full employment in the United States, there still are a lot of idle workers in Europe and elsewhere. That’s more unused capacity that keeps prices down.

High levels of debt also keep people from spending. That holds down prices. Indeed, the unwinding of a debt bubble is a strong deflationary force. A major goal of the aggressive central bank policies was to counter the deflationary forces of debt reduction.

Balancing the typical cyclical factors with those longer-term factors is tough. As long as the central banks don’t tighten too much, the sustainable growth we have now should push inflation a little higher in the next year or two. But I don’t expect inflation scares like we had in the 1960s and 1970s. A mistake by central banks or some kind of crisis could freeze consumers and cause prices to tumble. But the most likely result is a modest, irregular rise in inflation.

The Data

Manufacturing data finally showed some of the improvement that’s been in the business surveys for months. Industrial Production rose 0.4%. Mining provided the strongest increase in production, but the manufacturing component also increased 0.2% after declining last month.

Now, however, the surveys are showing some weakness.

The Empire State Manufacturing Survey was 9.8, down from 19.8. The current number still indicates strong growth. Last month’s number was considered unsustainable by most economists.

The Philadelphia Fed Business Outlook Survey also declined, to 19.5 from 27.6. This is the lowest level for this survey since November. This survey has been the strongest of all the Fed regional bank surveys this year and has been much stronger than actual economic data. While there was a sharp decline in the headline number, many of the components of the survey were even weaker.

Home builders are a bit less optimistic, according to the Housing Market Index from NAHB. The index was 64, compared to last month’s 66 (revised down from 67). The builders are concerned primarily about rising lumber prices. This will reduce the affordability of new homes despite strong consumer interest.

Yet, housing starts and permits were positive after three months of declines. New home starts increased 8.3%, and permits increased 7.4%. There were strong increases in both single-family and multi-family homes. But the previous months were so weak that the second-quarter totals for starts and permits were less than a year earlier.

The surge in housing starts led to a sharp rise in the index of Leading Economic Indicators from The Conference Board. It rose above expectations to 0.6% from 0.3%.

Retail sales for May registered their second consecutive monthly decline, though April’s decline was revised to a negative 0.1% instead of negative 0.3%. Sales were down almost across the board, with Internet retailers and building materials the few exceptions reporting sales gains.

As indicated earlier, inflation isn’t a worry. The headline Consumer Price Index had no change in the last month, and after excluding food and energy was up only 0.1%. The 12-month increase for the headline number was 1.6%, and after excluding food and energy was 1.7%.

Consumer Sentiment, as measured by the University of Michigan, declined again to 93.1 from 95.1. That’s the lowest level since before the election. The partisan breakdown shows Republicans becoming sharply less optimistic while Democrats are becoming a little more positive.

The Markets

The S&P 500 rose another 1.22% for the week ended with Wednesday’s close. The Dow Jones Industrial Average returned 0.55%. The Russell 2000 gained 1.23%. The All-Country World Index added 1.50%. Emerging market equities led the pack again with a 3.03% return.

Long-term treasuries rose 1.0%. Investment-grade bonds gained 0.68%. Treasury Inflation-Protected Securities (TIPS) returned 0.58%. High-yield bonds added 0.80%.

The dollar fell 1.06%. It’s now down 7.35% for the year to date.

Energy-based commodities had another strong week with a 2.16% return. Broader-based commodities returned 0.18%. Gold gained 1.88%.

Bob’s News & Updates

Do your heirs know how to handle an inherited IRA? If not, they’ll join the long list of heirs who made simple mistakes that triggered additional taxes and penalties. To avoid this result, be sure your heirs have a copy of Bob Carlson’s Guide to Inheriting IRAs.

The missing link in many retirement plans is a strategy for withdrawing money from the nest egg to ensure it lasts 30 years or more. If you don’t have a plan, learn more in the revised edition of “The New Rules of Retirement”

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