Uncommon Sense

Late Summer Data Key to Answering Transitory Inflation Question

"I continue to believe that the American people have a love-hate relationship with inflation. They hate inflation but love everything that causes it.”

- William E. Simon

Chief Investment Strategist

The debate about whether rising inflation is temporary or permanent rages on as summer starts. Investors hoping to get greater clarity on the inflation outlook from the Federal Reserve’s (Fed) Federal Open Market Committee (FOMC) meeting held on June 15-16 were disappointed. The Fed acknowledged the increase in recent inflation data and the improvement in the economy, raising its inflation forecasts for 2021 from 2.4% to 3.4% and pulling forward into 2023 the potential for two interest rate hikes. Yet, the Fed stuck firmly to the transitory inflation narrative.

The FOMC meeting, Summary of Economic Projections and Chairman Powell’s post meeting press conference resulted in more questions than answers. And investors’ confusion regarding the future direction of interest rates and inflation produced some wild post-FOMC meeting gyrations in financial asset prices.

Market participants are hypersensitive to subtle shifts in monetary policy, interest rates and inflation expectations. Regrettably, July’s FOMC meeting is also unlikely to provide investors the clarity on rates and inflation that they are so desperately seeking. Expect more of the same from Fed policymakers on July 28 — the target range for the federal funds rate will likely remain at 0 to 1/4 percent, rising inflation will probably be described as reflecting transitory factors and the Fed will presumably continue to increase its holdings of Treasury and agency mortgage-backed securities by at least $120 billion per month.

The early days of summer may be a good time for investors and Fed watchers to take those long overdue, pandemic-postponed vacations. But they should make sure they have their butts back in their seats with seatbelts tightly fastened in time for the Federal Reserve Bank of Kansas City’s Jackson Hole Economic Policy Symposium from August 26-28. The symposium combined with a slew of other end of summer data will finally enable investors to determine if inflation is truly transitory, as the Fed suggests, or more permanent.

The Big One

Every August, investors turn their attention to what’s going on at a Wyoming resort on the edge of the Teton mountain range. For nearly four decades, central bankers have used the Jackson Hole Economic Policy Symposium to plan and signal changes in monetary policy. Last August at the virtual symposium, Fed Chairman Powell announced a major monetary policy shift to average inflation targeting. That means the Fed would allow inflation to run higher than the standard 2% target before raising interest rates. In addition to the shift on inflation, Powell announced a policy tweak that changes the Fed’s approach to employment. The new language says the approach to the jobs situation will be informed by the Fed’s “assessments of the shortfalls of employment from its maximum level.” The prior language referred to “deviations” from the maximum level.1 The language shift may seem subtle, but it reflects the Fed’s view that a robust labor market can be sustained without causing an outbreak of inflation.

At the 2019 symposium, Powell set the stage for an interest rate cut by warning of significant risks to the economic outlook from uncertainty regarding trade policy. In 2014, then European Central Bank (ECB) President Mario Draghi laid the groundwork for quantitative easing (QE) in his Jackson Hole symposium speech. The ECB launched QE the following year and bought over 2.6 trillion euros of mostly government bonds. Similarly, former Fed Chairman Ben Bernanke signaled that a third round of QE was on the table in his 2012 speech at the symposium, while defending the Fed’s controversial bond purchases. The Fed launched QE3 the next month. Additional examples from 2008, 2007, 2005 and 1999 could have been chosen to underscore how central bankers use the Jackson Hole Economic Policy Symposium as a platform to signal important changes to future monetary policy.

Quietly the Fed has already begun to reduce extremely easy monetary policy. In early June, the Fed announced plans to begin winding down the Secondary Market Corporate Credit Facility. At the June FOMC meeting, in a technical move, the Fed raised the interest on excess reserves (IOER) from 10 basis points to 15 basis points. It’s hard to describe the increase as a tightening of monetary policy, but it’s certainly not a further loosening. And, the so-called Fed dot plot included in June’s Summary of Economic Projections potentially brought forward two interest hikes in 2023. Markets have taken notice as short-term interest rates have increased substantially. In his post-FOMC meeting press conference, Chairman Powell said that the Fed would give markets plenty of advance warning on tapering asset purchases. In line with recent history, the timing and size of tapering could be signaled at August’s Jackson Hole Symposium.

Help Wanted

The Fed has backed itself into a corner by relentlessly describing rapidly rising inflation as transient. Suddenly wavering from the temporary narrative would spook markets and undermine the Fed’s credibility. So, despite soaring inflation measures, don’t expect the Fed to budge from its transitory position on rising prices anytime soon. As a result, the ongoing recovery in the labor market will take on even greater importance than usual in determining the future path of monetary policy.

The labor market has rebounded strongly from the pandemic lows, the unemployment rate is 5.8%, down considerably from the 14.7% it reached in April 2020. According to the Bureau of Labor Statistics, US employers expanded payrolls by 559,000 positions in May, bringing the year-to-date total to nearly 2.4 million jobs. Sadly, the US jobs level is still about 7 million shy of where it was pre-pandemic and at the pace of May’s jobs gains it will take more than 12 months to recoup all of those lost positions. Fed officials have frequently cited these facts as justification for keeping monetary policy easy.

Fears about contracting COVID-19 at work, generous federal unemployment benefits, children home from school and supply chain disruptions have all been identified as reasons for the continuing jobs shortfall. But, by late summer most of these challenges will be receding.

The Center for Disease Control and Prevention (CDC) reports that the 7-day moving average of daily new COVID-19 cases is 13,997, compared with the highest peak on January 10 of 251,834, a more than 94% decrease. More than 60% of US adults have received at least one vaccine dose and the numbers continue to climb. COVID-19 cases are likely to fall as summer temperatures rise. Fears about contracting COVID-19 at work should subside throughout the summer months, possibly leading to more job increases.

Rates of US COVID-19 Associated Hospitalizations

More than 25 states have announced plans to end federal unemployment benefits from COVID-19 fiscal stimulus programs early. As of mid-June, four states have already stopped making the extra payments and all states will let the programs expire in early September. This is likely to boost job gains later this summer.

US Personal Consumption Expenditure – Day Care and Nursery Schools

Schools across the country will reopen their doors to students for in-person learning beginning in August. For example, New York City Mayor, Bill de Blasio announced in May that the nation’s largest school district will meet in person, five days a week with no remote option for students this fall. Having the nation’s children back in school will eliminate another obstacle standing in the way of potential job seekers this summer.

Availability of In-Person Learning

Finally, supply chain challenges should also begin to heal in the coming months. As they do, manufacturers are likely to bring back an increasing number of workers, further bolstering jobs data by the end of summer.

August Moon

In addition to the four items outlined above, recurring seasonal effects often result in large upside surprises and revisions to the August jobs report. By the end of summer, a rapidly falling unemployment rate could suggest that the US economy is approaching full employment. Combine that with several months of inflation data that far exceed the Fed’s 2% average inflation target and it will become increasingly difficult for the Fed to justify emergency monetary policy.

Revisions in August Nonfarm Payrolls, Seasonally Adjusted

Wildly, this potential end of summer job gains bonanza coincides almost perfectly with the annual Jackson Hole Economic Policy Symposium. Fed officials may use this as an opportunity to provide capital markets that promised advanced warning on changes to monetary policy. Investors may finally get the answers they’ve been seeking on anticipated changes in monetary policy and the likely future path for interest rates and inflation. Let’s just hope they like what they hear. Otherwise, investors should brace themselves for a brief bout of capital market volatility as the shift in expectations is digested.