In May 2020, a few months after we went into lockdown due to the COVID-19 pandemic, my weighing scale registered 210 lbs. This was about 35 lbs over my weight goal. The number on the digital display prompted me to make some serious changes to my level of physical activity and daily diet. Losing the first 15-20 lbs was relatively easy. But, it is the final 5-10 lbs, those last few pork chops around my waist, that I am still struggling to address. After trying for more than 2 years to hit my weight goal, I am thinking of adjusting my target upwards to 185 lbs. You might call it cheating or laziness. I consider it a new reality that I can live with. And Tik Tok, the 2022 encyclopedia, tells me that dad bods are in!
Inflation in the US
Now, apply this same weight loss logic to inflation in the US. This week, the July CPI report showed that inflation dropped from 9.1% YoY in June to 8.5% YoY last month. Prices of gas, food, commodities etc. have dipped and this is reflected in the latest retail inflation metrics. Even sentiment as measured by the University of Michigan survey showed that consumers were feeling 7% more positive about the economy, jobs and their personal financial situations.
No need to have a debate about whether inflation is transitory or not. It’s fundamental economics. When prices go up, consumers buy less. This brings down demand for the product, which increases supply of said product. As inventories increase, sellers are forced to consider reducing prices to attract buyers, thus bringing down inflation. And this is exactly what has been playing out in many sectors.
Lets take a few examples:
A month ago, the national average gas price rose above $4.60 and consumers felt the pinch. Higher gas prices hit us directly when we filled up our gas tanks and indirectly as we bought goods and services. So we adjusted our behavior. We bought less gas and we bought less “stuff”. As demand for gas decreased around the world, supply increased, prices dropped and kept dropping by up to 15% to the current sub-$4 national average.
Take a look at the housing market. We have reset from the days of long lines of buyers in front of a home that just went on the market. Sellers would receive tens of desperate, competing bids, trying to one-up each other to secure the deal. As home prices kept climbing and buyers showed no signs of slowing down, the FOMC raised interest rates to curb the enthusiasm. This resulted in 5+% mortgage rates and a 40-60% jump in monthly mortgage payments that was too much for homebuyers to bear. Housing demand slowed down, leading to less home purchases, fewer mortgage applications and lower home prices. Side effect of this: Rental rates have climbed significantly and are expected to stay hot until late-2023.
A higher inflation tolerance?
If these trends continue, we should see inflation drop below 6% perhaps by the end of 2022. But the US Fed’s target is 2% inflation and they have signaled multiple times about the need to keep raising rates until they achieve this goal. The first few % drops are going to be easy. As we get lower, it will get harder to squeeze out the last few drops of sticky inflation.
So what happens if inflation stubbornly stays north of 2%?
I am getting more and more convinced that US consumers will not care if inflation is 4% or 2% and the FOMC will have to adjust their target (see #2 below) upwards.
The US Fed’s challenge is four-fold:
- Maintain healthy employment (unemployment less than 5%)
- Keep inflation in check (target is 2%, however 3-4% is more realistic)
- Support economic growth (GDP growth norm of 2-3%)
- Calm the markets with clear communication and fact-based decision-making
We have enjoyed years of very low inflation in the US as compared to the rest of the world. This year, we experienced first hand what it is like to pay through our noses for almost everything. And the US consumer was unhappy, frustrated and concerned.
Fast forward to today, the consumer is feeling a little more positive about the future because the job market is still strong and prices are dropping. As this optimism continues to rise, demand for goods and services will increase. Prices and supply will find a higher norm, slowing down the rate at which inflation drops. The US GDP will bounce back to it’s historical averages (see #3 above) and the US Fed will have achieved the soft landing that they wanted. We could have an economic slowdown of sorts along the way, but a recession is looking less likely.
If the CPI stays stagnant at, let’s say, 3%, while unemployment is low and the US GDP is healthy, the FOMC is not going to adamantly keep raising interest rates and “break” the US economy (some would argue, even the global economy).
As the saying goes….if it ain’t broken, then don’t fix it.
Beachman (beachman.substack.com)