Friday Reflection | May 13, 2022
Inflation continues to be a troublesome pebble in the shoes of investors. Rapidly rising interest rates are intended to slow down and eventually reverse the momentum of price increases, but along the way, those same rate hikes dampen asset prices. Stock and bond prices continued to fluctuate this week, and to trend steadily downward as the Fed’s next interest rate increase is debated in the press.
The complex origins of today’s inflation may fool us into believing it is impossible to tame, and we worry the pebble will be with us forever. Past cycles of crisis and reaction reassure us that inflation will morph and recede. As this happens, reactions to the initial crisis create their own pattern of consequences. Some crises are politically initiated, such as the energy inflation of the 1970s, when the oil embargo and eventual gas rationing led to decades of political and personal commitments to conservation. Some are financially initiated, such as the mortgage crisis of 2008-2009, which led to a radical reduction in construction; housing starts have only recovered to 60% of their prior level.
Today, we face inflation that is hard to trace to a single source, and markets are worried that neither the easing of the pandemic nor actions by the Fed will bring it to heel. As is often the case, investors fear that today’s environment will persist indefinitely, and are tempted to act accordingly. In fact, investors who remain steady throughout cycles of change and reversals will see success over the longer term. This time is no different.
The Path of the Initial Crisis
The pandemic quickly became a global crisis in early 2020. Early on, China shut its economy down to pursue a policy of eradicating Covid entirely. Two years on, we know that there have been both direct consequences, and disquieting reverberations. Over six million people globally have died, and a multitude of weaker variants are spreading exponentially. While most developed areas of the global economy have learned to live with the virus, the global supply chain continues to have gaps in capacity and lack reliability.
As understanding of the disease grew and public policies emerged to support public health, individuals regained a sense of personal power to protect themselves as well as a sense of how to keep others safe. Social activities and travel have resumed, and people are more adept at managing their exposure. Economic recovery has paralleled the social recovery, and demand for goods and services has generally climbed back to pre-pandemic levels – outpacing the recovery of supply chains.
Navigating the Echoes
With the pandemic fading, investors are beginning to experience the echoes of policy decisions made early on in the crisis. Inflation is itself a complex reverberation of many aspects of the initial crisis response – most notably, the infusion of new money that the Fed and other central banks printed to support consumption when large swaths of the economy were essentially shut down.
The veritable flood of money provided by the Fed set the stage for an inflationary environment. Milton Friedman is known in finance circles for his insistence that “Inflation is always and everywhere a monetary phenomenon.” During the financial crisis of 2008-2009, the Fed used that commitment to monetary policy to rapidly provide liquidity to an economy that was seizing up. In the ensuing decade, investors behaved as though a low interest rate environment would last indefinitely. While interest rates did begin to rise in 2019, the pandemic brought a reversion to zero interest rates.
By early 2021, economic activity was recovering in the wake of vaccine distribution, additional federal stimulus was working its way through the economy, and at that point supply chain problems began to have a material impact on prices. The current lockdowns in China are again rippling around the world, reminiscent of their initial shutdown in 2020. In this context, the economy faces the dynamic challenge of stabilizing prices amid an ongoing mismatch of demand and supply. While the Fed’s interest rate increases are necessary to reduce inflation, interest rates can’t change the imbalances in production and distribution. This week’s shortage of baby formula is an echo of an echo, in the sense that there is very little cushion to expand production when a part of the ecosystem goes offline.
Beginnings of a Reversal
Energy costs have also been a source of whiplash in prices as economic activity recovered in 2021. After Russia invaded Ukraine in February, expectations hardened about the persistence of high energy prices. The price spike after the invasion has now retreated to its earlier trendline. That spike was reflected in a huge uptick in the energy component of the domestic CPI in March; in April, the annual inflation rate measure finally started moving downward, led by a -2.7% decline in energy prices. The subcategory of gasoline fell by -6.1%. Analysts currently project that annual CPI is likely to fall to half its current level of 8.2% over the next 9-12 months and settle closer to 4%.
Wage inflation appears to be reaching a plateau. The queue of container ships waiting off the coast of California has shrunk by half. The seemingly uncontrolled rise in the cost of housing is starting to respond to a doubling in mortgage rates since mid-August 2021, with the industry expecting a -35% decline in mortgage originations in 2022 compared to 2021.
Watching the Horizon
Consumers and investors alike will need to maneuver through the reverberating consequences of higher costs and lower asset values. Costs may stop rising but remain at a higher level than before. Plans for travel, remodeling, or retirement may need to be reworked with adjusted assumptions. Opportunities will emerge that weren’t previously imagined or considered – and over time, we will weave all those considerations into a new map for our future.
Inflation will likely recede as the year progresses, although there may also be new cycles of supply challenges, as well as an overall economic slowdown due to higher interest rates. We encourage investors to focus on the horizon. Whether adjusting assumptions for the future or adjusting to asset value declines, looking ahead and watching the horizon can help steady us in the present.
 Milton Friedman, from a talk he gave in India in 1963. Milton was a monetary economist, who received the Nobel prize in Economic Sciences for his work on (among other things) the complexity of stabilization policy regarding interest rates. He advocated steady, small expansions in the money supply rather than rapid and unexpected changes.
 Jason Douglas & David Harrison, “China’s Economic Slowdown is Rippling All Around the World,” The Wall Street Journal, May 12, 2022.
 Catherine Pearson, “What Parents Need to Know About the Formula Shortage,” New York Times, May 13, 2022.
 Greg Ip, “Inflation is Headed Lower – but Maybe Not Low Enough,” The Wall Street Journal, May 13, 2022.
 Diana Olick, “Bankers lower their mortgage demand outlook for the year as rising rates hurt affordability,” CNBC, April 13, 2022.
About Kate Campbell King, CFP®
Kate Campbell King is the Founding Partner and Chief Investment Officer at North Berkeley Wealth Management. Kate provides clients with a unique approach to their financial decision-making.
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