Today is a good day to add to this thread on inflation and the Fed. Below is something I wrote for myself, to check my thinking by writing it down, and will post here for comments. I am usually not a macro investor, but the emergence of inflation after 40+ years, has awakened in me a strong macro view. I wrote it down for myself also, so I have a record and don’t revise my recollection in the future, especially in the case that I am wrong. I am doing something like trading on this trend, selling puts and calls on shares I want to own, or already own, on the belief the market will be volatile and sideways for several quarters. Here is my write up, modified from my version as I can’t easily post graphs here.
I believe the high inflation seen in the United States, which first became visible in March of 2021, has at least three factors that will make it more persistent and difficult for the U.S. Fed to bring under control. The graph below shows some of the most important components of inflation. The three components of inflation I believe are important are housing, labor, and monetary policy. Monetary policy looms over everything else regarding inflation, but it merits separate discussion here.
First, housing. The cost of shelter in the U.S. has inflated upward from 2% in mid-2012 to around 3.5% in the four years before the Pandemic. After bottoming below 2% in February of 2021, the rate of housing inflation has shot up in an almost straight line to over 6% in August of 2022. Housing has been underbuilt in America since the GFC. The U.S. is now short by several million housing units. there is a hole in housing starts that was dug in response overbuilding in the early-to-mid 2000s. We are only as of 2021 recovering to the average rate of new housing starts of the previous 4+ decades. Given that it is difficult to build new housing in many places that need it, combined with the construction labor constraints that resulted from the GFC and the aging U.S. population, I think a shortage of housing is here to stay. But, with mortgage rates rising and different options to reduce demand for housing (staying put, living with family) and increase supply (high prices prompting old people to downsize, the surge in new construction that has been underway, reductions in new construction restrictions,) I think housing will flatten out and lead it to be a reduced, but persistent, source of inflation.
The second important component in my view of inflation is labor. I think there are three powerful factors affecting the U.S. workforce in effect currently. First is demographics. The U.S. working age population is declining as the Baby Boomers enter their golden years and are replaced by the “baby bust” of Generation X. The graph above left shows the reduction of more than 2% in the percent of the population that is working age since the late 2000s. Second is immigration. There is an oversupply of debate about the 45th President, but almost everyone agrees he wanted less immigration, and his administration’s immigration policy reflected that. This has led to a shortage of an estimated 1.8 million working age migrants, compared to the trend between 2010 and 2019, according to the Economist magazine. Third, the Pandemic pushed millions of workers out of service jobs, many of which were low-wage and unpleasant. Many of these people found a new career, or at least a new way to make money, when they were forced to do so. Many of them found it easier/better/possible. Now that they know how to do something different, they aren’t going back. These three factors have, in my view, been major contributors to the record-low unemployment rate. The aging trend can’t be stopped directly. It can only be backfilled with immigrants. Turning immigration around is going to be politically difficult.
Finally, the money supply. I think the Fed was too loose for too long. Now that so much money is out in the system and everyone is used to it, the pain is going to be real, large, and sustained to vacuum it back out. The simple math, not too simple I hope, is interest rates will need to get and stay above the level of inflation, long enough to slow the economy down. to tame inflation in the early 1980s, interest rates were above 15% for two years . Now inflation is well above the current Fed funds rate of 2.5% to 2.75%. I think the Market was wagering, optimistically, that inflation would do most of the work here; that it would come down and get under 4% or even lower without having to raise interest rates above that level. It is a bold statement for me to say I’m right and the Market is wrong, about the most central number in the economy. Why might I be right? I think two reasons. One, human optimism and not wanting to feel pain. Two, it has been more than forty years since we had high inflation. The majority of people in the economy and making the biggest decisions that affect the economy have little to no direct experience with inflation.
For these reasons, I believe we will continue to have days like today, when Markets were surprised by a high inflation reading and sold off. I think the market will go sideways for several months, maybe even a year or longer, oscillating between unfounded optimism that the Fed has done enough and the periodic hard slap of inflation, telling everyone there is more pain ahead. I think a soft landing is too small a needle to thread.