Inflation continued its rise during the fourth quarter of 2021, reaching a level not seen in 39 years. It is reasonable to suspect that maybe we are not in a business-as-usual time economically. Perhaps the Federal Reserve’s experimental QE policy that has been followed for the last 10 years has generated sub-surface forces that, while long predicted, are now becoming manifest.

The Economy

The consumer price index registered a year-over year increase of 6.8 percent in November, the highest rate increase since January 1982. Likewise, single family home prices increased by 9.3% over last year’s. Supply of existing homes for sale remains constrained, down by 11.1%, suggesting that a buyer’s market may still be a long way off. For its part, unemployment has dropped to 4.2% as the lockdowns eased and economic activity continued to rebound. The labor force participation is only 61.8% though , having recovered about ½ of the pandemic loss. The lower number of people wanting to work also shows up in a comparison of 6.5 million new hires vs. 11 million job openings in October.

For its part, GDP increased at an annual rate of “only” 2.3% in the third quarter, but the current-real time estimate for the fourth quarter is 7.6%, showing a lot of variation as economic activity regains its footing. Wages have increased by 3.7% since last year, a significant increase from the 2.4% recorded a year earlier, but nowhere close to the 6.8% CPI increase over the same period, suggesting that wage pressures could continue to promote inflation over time.

The Markets

Stocks performed well in October, and then got hit as the Fed announced a change in its QE policy in November. Large cap stocks recovered again, ending higher, but small and mid- sized company stock prices remain below their November highs. Treasury bonds rose a little during the quarter. Corporate bonds finished flat.

Inflation

While the 6.8% CPI increase is not extraordinarily high on a historical basis, it is certainly different than the last 39 years. After expecting inflation to be “transitory”, the latest readings have caused the Fed to abruptly change policy. It no longer promises to maintain its easy money policy for years, but rather has announced the wind down and stop of its Quantitative Easing (money printing) program by early 2022 and expects to raise interest rates several times in 2022

After posting a benign 1.37% CPI at the beginning of the year, where did the enormous increase come from? The transitory expectation was based on supply problems after the initial COVID lockdowns. Economics teaches that prices rise when the supply of goods is constrained. Prices fall when people are not so interested in buying. During the initial COVID period, the locked-down population was not very interested in buying, traveling, or restaurant meals, so prices remained low despite the supply issues. When people got back to a more normal life, demand increased and prices rose.

Because people have budget limitations, if prices rise, demand usually falls, so the two have remained generally balanced for decades. This time however, money has been readily available by virtue of Fed and government policy. There is more than enough money available to for the economy to function and interest rates are low, which allows higher prices to be paid. In fact, consumer goods and services are the last hold-out. Financial assets have reflected the inflationary policy, reaching historically high valuations. More recently, real estate has seen the same effect, not to mention Cryptocurrency. The definition of “demand-pull” inflation is too much money (which we have) chasing too few goods (which we also have).

If the demand-pull inflation goes on too long, inflationary expectations become baked into expectations of wage and commodity price increases, so the cost of making goods and providing services increases. This is “cost-push” inflation, which becomes embedded in the fabric of the economy and becomes an increasing trend that is difficult to reverse. It took the Fed under Paul Volker to raise the Federal Funds Rate to 20% in 1981 to stuff the 1970’s inflation genie back in the bottle. The current Fed has already found itself behind the containment curve. Maintaining the accommodative policy for so long, during the long economic expansion, has placed the Fed on a tightrope. Falling off on one side by maintaining easy money is being shown to promote increasing inflation. Falling off the other side by reducing accommodation could throw the markets and economy into decline – exactly the opposite of their policy objectives.

While the Fed has its problems, the government fiscal policy also may be aggravating the problem. Policies like free “helicopter” money given to everyone, the $1.2 trillion infrastructure bill, $768 billion defense bill and the proposed $1.75 trillion Build Back Better Bill are all be funded by new debt, which adds to the money supply and creates even more money that will be available to chase a limited amount of goods.

Although the policy announcement added fuel to a market sell-off in November, thus far the Fed has successfully avoided creating a market “taper tantrum”. But by taking the policy changes slowly, it may be postponing and increasing the inevitable “correction” from the current lofty asset valuation levels.

The last time the Fed reduced asset purchases, in the last half of 2014, the market continued to rise until the middle of 2015, at which time it rolled over into a mini-bear market dropping 14% over seven months. That performance suggests that there will be a market impact from the policy change, but it may not be immediate or overly severe. The eventual financial impact, however, may depend on how resistant inflation becomes and how dedicated the Fed and our politicians are to fixing the problem.

This may not be a short-term event. Inflation of 6% was near the current rate in 1970. That rise was reversed for two years, falling back to 3% by increasing the Fed Funds interest rate to over 9% and inducing a recession. Inflation continued to increase with each new short-term business cycle for the next nine years. During this period the government introduced wage and price controls, which seemed like a good idea at the time, but in the final analysis did not work. Likewise, the current politicians, who are blaming greedy corporations for our current condition, while promoting mega-spending legislation, are ignoring the real issue.

We are witnessing the result of a natural economic cyclical process that can be either ameliorated or exaggerated by government policy actions. It may be short or it may be long. Most people living today have never seen inflation this high. Most investors today never have seen the dislocations resulting from a decade of negative real (inflation-adjusted) returns. It may be worthwhile to ask, if the Fed were to fall off the tightrope in one direction or the other, how would I change my strategy? The first step is to recognize that the future may not look like the recent past forever. Then m entally place yourself in an inflationary environment as best you can imagine. Would I change my approach to s pending or saving? How might this affect my retirement?

Incidentally, our LFM&P financial plans model clients’ finances using the characteristics seen in the 1970s. This allows them to see whether their current plans are sustainable under at least one set of adverse conditions and guide them to see where changes can be made in planning and investment strategy to accommodate those conditions, if they were to occur. An exercise of this type, that is re-evaluated periodically, is a good way to maintain confidence in your financial strategy and actions as conditions develop.