Killing it Softly: How the Fed should Fight Inflation

26 Apr

Former keynote speaker at RAO - the Americas, Chief Global Strategist at JP Morgan, David Kelly, always makes you think when he posts an article on market activity, stagnation or, in this case, inflation. That he has got me humming the Roberta Flack tune is a bonus. For now.

Published on April 25, 2022

David Kelly

Chief Global Strategist at J.P. Morgan Asset Management

63 articles

Economic data in the week ahead should highlight a stumble in economic growth and a surge in inflation in the first quarter. While second quarter numbers will likely partly offset both of these trends, they will remind investors of the challenges faced by the Federal Reserve in trying to return the economy to a path of steady growth and moderate inflation. While some Fed officials have advocated very aggressive tightening, both the likelihood of near-term moderation in growth and inflation and longer-run disinflationary forces suggest it would be wiser for the Fed to take a slow and steady approach in battling inflation.

On the growth side, the key release this week will be first quarter real GDP, due out on Thursday. We currently expect a sharp deceleration to 0% growth from a 6.9% gain in the last quarter. It should be noted that this probably overstates any underlying deceleration in the U.S. economy and mostly reflects some very sharp swings in inventories and trade.

Looking at GDP from the demand side, we estimate a very solid 4.7% gain in real consumer spending in the first quarter, driven mainly by gains in leisure, entertainment and travel as pandemic effects faded and some increase in light-vehicle sales from supply-constrained levels in the fourth quarter. We estimate that fixed investment spending rose by an even stronger 13.2% annualized, as companies took advantage of low interest rates and strong profit gains. Investment spending gains should have been very broad-based, across equipment, construction and R&D.

However, it appears that government spending lagged behind, growing by less than 1.0% annualized. Employment across federal, state and local government grew by a modest 46,000 or 0.8% annualized in the first quarter and is still down by more than 700,000 from pre-pandemic levels. It may be that, in an economy that is chronically short of labor, the government sector just doesn’t have the flexibility in compensation to fill vacant positions. Similar issues may have impacted public construction which, in January and February was essentially unchanged from the fourth quarter in nominal terms and down when adjusted for inflation.

More importantly, both inventories and trade were likely major drags on first-quarter GDP.

According to the Bureau of Economic Analysis, real inventories grew at a record $193.2 billion pace in the fourth quarter, converting a modest 1.4% gain in real final sales into a 6.9% increase in real GDP. Annual revisions, due in late July, may well reduce this estimate. However, for now the fourth quarter estimate stays in place and any reduction in real inventory accumulation will detract from first quarter economic growth.

Such a reduction seems quite likely based on both a slower pace of accumulation in nominal inventories in January and February and significantly higher wholesale inflation. March reports on Durable Goods and Wholesale and Retail Inventories, due out on Tuesday and Wednesday respectively, should allow economists to tighten their estimates of first-quarter inventories. However, for now, we estimate only $90 billion in real inventory accumulation in the first quarter, subtracting more than 2 percentage points from real GDP growth.

International Trade should also be a big negative in the GDP report reflecting both the strength of U.S. consumer demand and some of the impact of a rising U.S. dollar. In January and February combined, nominal imports of goods and services were up 19% annualized from the fourth quarter while exports were up just 1%. Moreover, export prices rose more quickly than import prices in the first quarter, implying a more significant deterioration in the real trade numbers than in the nominal numbers. Data due out on Wednesday showing flash estimates of Goods Trade in March should allow for more precise estimates. However, based on what we know now, it appears that the real trade deficit jumped from a record $1.35 trillion annualized in the fourth quarter to a new record of $1.48 trillion in the fourth, lopping another 2.5 percentage points from GDP growth.

Summing up the demand components, this suggests 0% real GDP growth in the first quarter which may well lead to further worries about stagflation.

It is also worth noting that these numbers will take a bite out of pandemic-era productivity gains. One small silver lining in the very dark cloud of the pandemic recession is that productivity appeared to rise substantially, presumably due to the adoption of more efficient on-line shopping or using remote communications in place of physical meetings. In 2020 and 2021 combined, the output per hour of the non-farm business sector grew by 2.3% annualized, more than twice the 1.0% annualized pace achieved over the prior 10 years.

However, if first quarter real GDP growth is essentially zero, this will have occurred in a quarter where payroll employment rose by 4.8%. This implies a significant drop in productivity and we now estimate that productivity in the non-farm business sector rose by just 1.4% annualized over the past two and a quarter years – only a modest improvement from the prior decade.

We expect that both economic growth and productivity growth will pick up in the second quarter. Still, first-quarter weakness suggests that economic rebound from the pandemic is losing momentum.

While the Federal Reserve will not be unhappy to see some slowdown in an overheating economy, they are clearly impatient for some better news on inflation.

Friday’s report on Consumer Income and Spending will contain the government’s latest read on inflation as measured by the personal consumption deflators. We expect the March headline consumption deflator to log a 6.8% year-over-year gain, its strongest increase in over 40 years.

That being said, it looks likely this will mark a peak in the inflation cycle. Oil prices, although still running above $100/barrel, are down from their March average while food commodity prices are roughly unchanged from very high March levels. Used car prices have fallen slightly in recent months and light-vehicle production, while still down from pre-pandemic levels, climbed to its strongest level in over a year in March, helping alleviate chronically low inventories. Most of the rebound in airline fares also now appears to be behind us.

However, because of fast-growing wages and rents and elevated inflation expectations, we expect inflation to only back off slowly. By the fourth quarter of this year, we expect the headline consumption deflator to be up 5.0% year-over-year and the core consumption deflator to be up 3.7% - both still well above the Fed’s 2% target.

The Federal Reserve seems very well aware of this and the last week saw a number of Fed officials make hawkish comments about the need for a swift increase in short-term interest rates. Based on these comments, it now appears likely that the Fed will increase the federal funds rate by 50 basis points at their May and June meetings and that they will formally announce a plan to reduce their balance sheet at their May meeting.

Futures markets have fully priced in this hawkish tilt, with contracts now implying four 50 basis point rate hikes in May, June, July and September followed by two 25 basis point hikes in November and December, taking the funds rate to a range of 2.75%-3.00% by January 2023. One Fed official has even argued for a more aggressive stance, pushing the funds rate to 3.5% by the end of this year.

However, such aggressive action would likely be a mistake.

Slowing economic growth and a resolution of some supply chain issues should cause the inflation rate to moderate over the rest of the year and in 2023. Moreover, because there is such a financial incentive to fix supply changes and replenish inventories, it is quite possible that within a few years, supply chains will have surplus capacity and that shelves will be over-stocked, exerting deflationary forces on the economy.

Beyond this, some of the powerful forces that have eroded inflation over the past 40 years remain in place.

Trade union membership continues to decline with just 10.3% of employees being members of unions in 2021, down from 10.8% in 2020 and over 20% in the early 1980s.
Information technology continues to make it easier for consumers to find the cheapest price for goods and services – a trend that the pandemic will likely only accelerate in the long run, and,
As the surge in pandemic assistance to low and middle-income households abates, the effects of income inequality are likely to reassert themselves, reducing the demand for goods and services while increasing the demand for financial assets.

In short, while inflation won’t die out quickly without a recession, it should gradually drift down. If this is the case, the Federal Reserve should have the patience to let it do so rather than try to speed its decline at the risk of tipping the economy into recession.

Ultimately, we think this is what the Fed will do and so, after some pretty hawkish signals in recent months, their tone could turn a little softer as the year goes on. For investors, this suggests that there is no need to panic, despite sharp recent increases in long-term interest rates and Friday’s plunge in U.S. stocks. Rather it is a time to check the valuation of assets more carefully as the U.S. and global economies transition to more normal economic growth but somewhat higher inflation that was seen in the decade before the pandemic.

For more of my insights, tune in to my latest episode of the Insights Now podcast.

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