The Fed & Inflation

Market Memo

November 2021 – Dan Zalipski, CFA®

Seems like everywhere you look the prices of goods and services continues to creep higher. The latest Government report regarding inflation showed a 6.2% jump in consumer prices year-over-year, the most since December of 1990.  There is evidence that most of the inflation we see today is related to the unusual supply shocks and strong demand associated with the economic restart coming out of the pandemic.  Due to the unique nature of the inflation, the ongoing debate throughout the year has focused on how long the current bout of inflation may last, and what that implies for the monetary policy coming out of the Federal Reserve. 

The Fed believes inflation will be transitory.  In other words, once the supply chain issues are resolved, the rate of inflation should decline back towards its longer-term average (between 2-3%).  There has been evidence of this in certain areas.  Some commodities such as lumber and iron ore, saw their prices more than double in the first half of the year followed by a dramatic selloff coming into the second half of 2021.  As of this writing, both are trading lower than where they began the year.  Still, other areas of our economy feeling inflation pressures are less likely to be transitory, such as wages and housing. 

In the past, the Fed would preemptively hike interest rates to tamp down on inflation before it had a chance to set in.  Departing from that standard response, last year the Fed signaled that it would tolerate higher inflation relative to past periods, in exchange focusing on full employment.  Raising rates too soon runs the risk of cutting the economic recovery short.  On the other hand, waiting too long runs the risk of inflation climbing higher than expected, requiring a more aggressive response from the Fed, potentially in the form of rapidly rising interest rates. 

The Fed has stated that they believe the first rate hike will occur in 2023.  Should these monthly inflation reports continue to run hotter than expected, the Fed will likely have to act sooner in raising rates or risk letting inflation get out of control.  In the past, the market has been able to absorb rate hikes that are slow and predictable.  On the other hand, rapidly rising rates have the potential to create substantial volatility in both the stock and bond market.  The next monthly report on inflation will be released just days before the Fed is set to meet to discuss policy.  Investors all but expect rates to increase, but the timing and pace will be critical to determining the potential impacts on the markets.

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