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  • Writer's pictureEng Guan

Why Is Inflation Not Coming Down Fast?

The June FOMC minutes are out last week. There is nothing much that we don't already know. Most Fed members are in favor of further hikes. And if you check against where the Fed Funds trade now, the market is anticipating another firm hike this coming FOMC. Thereafter, they expect Fed to pause (with risk tilted towards the upside for this year) till early 2024 before starting to cut. But of course, things can still change. As long as core inflation remains far above the Fed's target and the economy still shows that it is going strong and capable of absorbing more hikes, then we might see more of it down the road.

That is precisely what sparked a market selloff when ADP employment figures came in more than twice the consensus estimate last Thursday. A safe haven is hard to find on that day. Stocks sold off across all sectors. Bonds, Gold, Oil, and Reits, none were spared as well.

If only inflation fell to levels near Fed's target, then the pressure of rising rates could be lifted off our backs. But why is inflation not coming down as fast despite one of the most rapid and massive series of rate hikes since the 80s? If you read around, you will hear different opinions about it. Here's a summary of what I have seen, and some echoed my own views.

1. Monetary policy effects have a long lag of 18 months before impact can be seen.

The role of a central bank is critical and far from easy. Because it can take 18 months or longer for their policy decisions to be felt in the real economy. That means to do their job well, they really need a crystal ball that can see into the future so that they can send signals to the market and make adjustments to the interest rates in time. But if they can really do that, we wouldn’t have landed ourselves in this fix today. With the benefit of hindsight, we now know they responded late to inflation when it showed signs in 2021 by brushing it off as transitory. Now, it is like taking forever to come down. Having said that, central bankers are usually behind the curve. And that is not to blame them. It is always easy to point fingers. If we put ourselves in their positions, we may not have done any better.

Read more about this here.

2. There is a shift from more capital-intensive manufacturing to capital-light services industries.

The US, or for that matter all advanced nations, have been shifting its economic base from manufacturing to services. As of 2023, only about 8.8% of the US workforce is in good-producing manufacturing jobs. The former tend to be more capital-intensive and sensitive to interest rates when compared to the latter. It is not that difficult to picture why that is the case. If interest rates went sky high, your dream home or car might have to wait, but it will probably do little to hold you back from dining at your favorite restaurant or taking your annual vacation trip. It is not that interest rates have no impact on the service industry, it just takes longer for it to be felt. So that means, you might need to wait a while more ...

Services vs Manufacturing Employees ( 1939 - 2023)
Services vs Manufacturing Employees ( 1939 - 2023)
3. A tight labor market that continues to bolster wages and support inflation.

Despite a rapid and huge 5% increase in rates over the past 18 months, it has hardly dented the US job market. In part, this is due to a large vacuum created during the Covid-19 period in 2020. In just a few short months from March to June 2020, the US economy shedded over 20 million jobs based on the published Non-Farm Payroll numbers then. While it did take some time for hiring to climb back, it was no less ferocious. Since Covid-19 recovery, 22 million were put back on payrolls. And the strength is persisting as employers on the services side continue to show a healthy appetite for workers. This year, we saw the unemployment rate hitting new lows alongside healthy wage growth. With people still having jobs and enjoying good pay, it will take longer before they will feel the pinch from inflation and cut back on their spending which is needed to dampen demand.

US Unemployment Rate (1950 - 2023)
US Unemployment Rate (1950 - 2023) (Source: FRED)
3-Month Moving Average US Median Hourly Wage Growth
3-Month Moving Average US Median Hourly Wage Growth (Source: FRED)
4. Household financial obligations as a percentage of their disposable income are also lower today than levels seen in 2008 and 2000.

If the amount of money you need to set aside to pay for things like mortgages, rents, cars, insurance, and property taxes is not a big portion of your disposable income, then you are still in financially good shape. That means you have room to spend on goods and services. The financial obligations of US households today have dropped and are well below levels seen in 2000 or 2008 before the recession hits. In comparison, we are in a much better position now.

Household Financial Obligations as a Percentage of Disposable Income
Household Financial Obligations as a Percentage of Disposable Income (Source : FRED)
5. A prolonged era of ultra-low rates and money printing before this and a delay in reacting to inflation.

The US has gone into an unprecedented money printing mode both in terms of scale and duration since the Great Financial Crisis in 2008. Several attempts at ending it have met with failures with the most spectacular one in 2020 when Covid-19 hits. More money was printed in less than 2 years from 2020-2021 than in over a decade between 2008-2020. During these 15 years, the debt Federal Reserve held ballooned from US 740 billion to more than USD 6 trillion before the rate hike cycle begins in 2022. And even after one of the most aggressive tightening cycles since the 80s, Federal Reserve is still sitting on USD 5.7 trillion of debt. It will take a long and hardline approach to wean the effects of easy money off the system. You might need another Paul Volcker back for this job.

Ending Note & Keep a watch on inflation

CPI data will be out this Wednesday. Keep a watch on it. It will give us a sense of whether we are really at the end or even near the end of the rate hike cycle. But in the meantime, the best bet to weather market uncertainties is still a well-diversified portfolio. Having said that, it is not your run-of-the-mill diversification that only spread across different stocks. A well-diversified portfolio is one that is carefully calibrated across different assets and strategies, each with its own strengths and weaknesses under different market regimes (check out the multi-strategy model portfolio). As with any good investment strategy, it is not only about the ability to make money but also about the ability to preserve the money you make.


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