The shift in U.S. Federal Reserve (Fed) policy over the past year may signal a preference to generate inflation. Fed Chairman Jerome Powell told investors there is no longer a 2% upper bound for inflation. Any inflation registered from base effects of the economic weakness in 2020 will be ignored, as will any supply constraints during economic reopening that cause temporary inflation.
Powell effectively has dismissed any of the potential causes of inflation for the rest of 2021 as being insufficient justification for higher policy interest rates. He has also reiterated that the Fed’s goal is maximum employment because the Covid-19 pandemic hit the lowest-paid workers hardest. Further, the Fed will not change policy based on forecasted data, but, rather, only on existing, backward-looking data. The central bank will no longer react in anticipation of achieving target conditions, but will take action well after those conditions have been met. This underlines the bias to let the economy run “hotter for longer.” The Fed has stated that it will raise interest rates late, and raise them faster and potentially higher in magnitude when that time comes.
Inflation may be coming
There are several global macro factors which signal that inflation may come about in the not-so-distant future. For example, demographic shifts and behavioral changes that have occurred in response to the coronavirus pandemic support a rising-inflation outlook. For example, widespread work-from-home policies may have started as an emergency Covid response, but for a portion of the population, it is the proverbial “new normal.” Many people no longer need to live near where they work.
Even if 10% of the workforce has the option to work from home 100% of the time, the resulting shift to lower-tax and less-expensive housing areas can see demand overwhelm available housing supply. For example, the number of available single-family homes in the Florida markets of Tampa, St. Petersburg and Clearwater has dropped almost 60% thus far in 2021. This decrease in inventory comes along with concurrent increase in median sales price of more than 15%.1 Local real estate agents attribute this increased demand to families leaving Northeastern cities.2 There is a similar migratory trend of families moving out of California into Texas. Both of these trends were underway long before Covid, but have accelerated since February 2020. The effects on local housing prices outpace traditional inflation measures. The price of lumber is up 249% over the last 12 months and is but one of the affected prices.3
Another trend pushing the global economy toward higher inflation is deglobalization. For years, globalization has been a force keeping inflationary pressures in check, as manufacturing and consumer- product production have been moved to emerging economies with cheaper labor. This “deflation pulse” from imported consumer goods has offset other portions of the product basket that had inflation.
But now deglobalization trends are ticking up. Today, many nations realize, for example, that China, while inexpensive, isn’t necessarily the best place to manufacture goods and products. Doing business with China comes with regulatory and supply-chain risks. Therefore, outsourcing manufacturing to China to keep expenses down may not always be the best solution, even if it is an inflation-friendly one. This is especially true as environmental, social and governance (ESG) trends continue to become higher priority.
The U.S. government and European Union issued joint sanctions against China for human rights abuses in late March of this year, a multilateral response that the previous U.S. administration was ineffective in achieving. Some corporations now worry that it may even be necessary to decide whether they will transact with either China or its rival Western nations exclusively. Smaller-volume supply chains are easier to disrupt and are less able to adjust to variations in demand without large price changes.
Decarbonization also may nudge inflation higher. There’s a global push toward decarbonization to offset the damage and danger of climate change. The three largest economic blocks on earth — China, the United States and Europe, a combined $51 trillion worth of GDP4 — regard decarbonization of the economy as a top-tier priority. This has kicked off a simultaneous shift toward renewables and the electrification of economies.
Demand for renewables is high and trending higher, which could spark higher prices as supply struggles to meet demand. Although some production processes can achieve lower costs with higher volume, the materials used, including silver, copper, aluminum and lithium, as well as the technical labor needed, all still follow supply-demand principles: higher demand will push costs higher. As environmental standards increase, more palladium will be needed in the pollution-control devices on gasoline-powered autos. Palladium prices have averaged 36% gain per year for the past five years, a sign of the sustained pressure environmental policies can put on supply.5
None of these trends is inherently bad. In fact, these trends are largely positive. What makes them so impactful in terms of oft-feared inflation is their disruptive power and the shotgun chain reaction they set off. The way these trends have taken hold has been like yelling “fire” in a crowded theater — everyone makes a move at once. This is why they suggest so strongly that inflation may be coming.
The Fed has an asymmetric bias to allow the economy to run hotter than in the past. This is of special concern since we currently face some of the easiest monetary policy in history and, at the same time, fiscal policy has created the largest deficit spending since World War II.
Learning to welcome inflation with open arms
What would be much scarier than inflation is deflation. The ratio of global debt-to-GDP rose to 356% in 2020, up 35 percentage points from 2019.6 For perspective, consider that during the Global Financial Crisis,7 this ratio rose only 10% in 2008 and 15% in 2009.8 This massive increase reflects both economic contractions in the face of the coronavirus pandemic in 2020, which reduced GDP, and the mountain of debt issued to prop up shrinking economies. If we have a period of deflation, that debt would be even more difficult to pay off in the future by raising the real, after-inflation value of the debt into the future.
Steady, moderate inflation will help hold up these economies as they chip away at the real value of those mountains of debt. Consider an extreme example. Over the five-year period from 1977 to 1981, cumulative inflation was 50%.9 The purchasing power of the U.S. dollar fell by half. A company that owed $1 million in debt in 1977 still owed $1 million in 1981, but that $1 million was only worth $500,000 in real terms by 1981. It was easier for the company to repay the debt in 1981 than it was in 1977. Low interest rates and massive debt issuance have helped countries withstand the coronavirus market shock in the shorter term. However, in the end, inflation will need to outpace interest rates so that the real value of debt stays lower. Mild inflation makes the existing debt easier to pay off, while deflation makes the debt difficult to repay. Keeping interest rates low and inflation moderately higher is the Fed’s goal as it keeps the financing costs low and erodes the value of the principal.
Then the question becomes: At some point will the Fed run out of tools to keep interest rate slow? The current Fed policy is very dovish. The Fed’s balance sheet has grown because it has been purchasing U.S. Treasuries and keeping financing rates low. In February 2020, the Fed’s balance sheet was $4.1 trillion, while the latest, reading, as of March 31, 2021, was $7.6 trillion.10 With intervention of this magnitude, we should not expect market interest rates to reflect inflation concerns.
Nonetheless, there is sufficient powder to fuel consumer-led inflation. Personal savings are roughly $1.3 trillion higher than a year ago. M2, a measure of the supply of money in the economy, rose 26% in the past 12 months.11 This represents one of the fastest increases in history. As the economy reopens, people can spend this money and the “velocity of money”12 will increase and drive inflation. The Fed has a minimum 2% inflation target until the U.S. economy reaches maximum employment. But the Fed has a dubious record of timing policy shifts correctly, let alone after the largest quarterly GDP contraction and expansion in history.
Why commodities in times of rising inflation?
Commodities may make a good hedge against surprise inflation because they’re often the cause of the surprise inflation. When inflation rises, commodity prices tend to rise because they’re at the root of the issue on either the supply or demand side that sparks the inflation in the first place.
Commodity prices can rise without much notice. For example, South American planting regions recently have been experiencing a drought, which has pushed the prices of agricultural goods higher. This is attributable to unpredictable La Niña weather patterns, which cause winds to blow warm water in the Pacific Ocean toward Indonesia. This causes cold water to surface off the coast of South America. This cold water keeps precipitation lower than normal in South America, to the point of severe drought.
But increased demand for goods and the commodities used to make them can occasionally be predicted. The Fed is specifically targeting maximum employment in the lower quartile of the income range. This group is more likely to spend its increased earnings on goods such as washing machines and cars, rather than resort vacations and trips to the spa. Commodities may capture an increase in goods demand.
The demand increase occasionally may keep higher prices from balancing the market for an economy. The story of palladium in the past five years illustrates this principle well. Demand for palladium, which is a key component of catalytic converters, integral parts of cars’ pollution-control systems, has risen in the past five years. We attribute this to increasing demand for cars with better emissions standards, particularly in China. Nonetheless, the palladium supply hasn’t risen in lockstep with the demand because mining it takes time, for one thing. For another, it’s a byproduct of mining for other metals, so mining companies aren’t likely to drill just for palladium. Palladium itself, by nature of what it is and how it’s acquired, has driven its own sustained undersupply.
Palladium is just one example that illustrates how commodities may present attractive opportunities for investors in times of rising inflation. Similar stories are scattered throughout the history of commodities investing.
While rising prices can be a tough pill to swallow, moderate inflation is crucial to keep the level of debt sustainable. Opportunities exist even in times of rising inflation and increased regulation, like the one we anticipate. In our view, there is a compelling case for investors to consider commodities when they think about the current and future inflation landscape.1 Greater Tampa Realtors, tamparealtors.org, 2021
2 Bay News 9, “’Exodus From the Northeast’ Continues to Hit Central Florida, Tampa Bay,” March 15, 2021
3 Business insider “https://markets.businessinsider.com/commodities/lumber-price” April 12, 2021
4 Gross Domestic Product – the total monetary or market value of all the finished goods and services produced within a country's borders in a specific time period.
5 Source: Bloomberg, April 2021
6 Axios, “Global debt soars to 356% of GDP,” February 18, 2021
7 Refers to the period of extreme stress in global financial markets and banking systems between mid 2007 and early 2009.
8 Axios, “Global debt soars to 356% of GDP,” February 18, 2021
9 Bureau of Labor Statistics, Inflation calculator, April 2021
10 Federal Reserve of St. Louis, April 2021
11 Federal Reserve of St. Louis, January 25, 2021
12 The velocity of money is a measurement of the rate at which money is exchanged in an economy.
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