Inflation: Real Data and What to Do Now

By Brian Seay, CFA

Founding Partner, Capital Stewards

The key to smart investing over time is discipline. Specifically having the discipline to follow the data when everyone else makes decisions based on emotion. Given this, we like to revisit prior analysis consistently to understand the economy and markets instead of jumping from hot topic to hot topic. In this note we are revisiting our inflation work from August of 2021. As we expect, inflation is higher but has not reached double-digit levels. Thankfully, everyone was able to leave their disco pants safely in the back of the closet. But where are we going from here?

Sources: FRED, CBO

When assessing the key drivers of inflation now, we again start with the U.S. Output Gap. This measures the actual economic performance of the U.S. against its “potential” GDP as forecasted by the Congressional Budget Office (CBO). In practice, potential GDP growth is simply a straight diagonal line increasing by 1.8%-1.9% year over year. Even though the estimate may be simple, it does provide a long-term steady number that can be compared against actual GDP results. Last August, the Output Gap was closing in on zero, which is indicative of an overheating economy and inflation. Currently, we see the Output Gap moving slightly lower. This should reduce some of the steam in the economy and help inflation come off the boil.

Source: FRED

The slight reduction in real versus potential GDP is also beginning to show up in the labor market. The number of available jobs according to the JOLTS survey has started to decline as companies cut planned expansions and begin to lay off workers. While initial unemployment claims started to increase slightly in Q2 of this year, the total unemployed population has remained essentially flat. The gap between demand for workers and available workers has likely peaked, but the economy has a long way to go to slow enough to bring the supply and demand for workers back in balance. That means a difficult hiring environment for many more months and higher compensation for workers. So, what does all of this mean for inflation and rates?

As we expected last year, inflation has risen substantially. However, if we zoom in, you can see that core inflation has begun to roll over. Core inflation excludes the impact from the supply of food and energy commodities, and thus is more closely related to the underlying economy and labor market. As labor becomes slightly more available, core inflation should continue to trend down.

What does all of this mean for investors? As you can see from both CPI charts, inflation is still significantly above average. From 2000 through 2019, inflation averaged just over 2% annually. It will likely take many months to fall back to those levels. It’s also possible that inflation remains in the 3% to 4% range for the long-term. The Fed would like for inflation to be closer to 2%, but there is no reason why the economy cannot grow with inflation in the 3% to 4% range as long as the trend remains to the downside (see the 1990’s as an example). Because inflation continues to be above its long-term target, the Federal Reserve has signaled that they will continue raising interest rates to bring inflation down. Again, predicting the exact level of future interest rates is challenging and less relevant for long-term investors. Direction matters more. Given history and current data, we expect the level of short-term rates to continue to rise over the rest of 2022 and early 2023. Rising rates will slow the economy and help bring the labor market back into alignment. As we mentioned in our Mid-Year Report Card and Outlook, histocial data suggests that the Fed will need to move rates into the 4%-5% range to see core inflation drop down. That creates a challenging market for short-term bond portfolios. As usual, diversification wins the day. More diversified bonds portfolios that include corporate debt and longer-term bonds can perform well as long-term rate expectations go lower. Commodities are used in portfolios during periods of high unexpected inflation. Given the data above, inflation seems to be baked in now thus we see significant commodity price outperformance as unlikely short-term unless an unpredicatble geopolitical event occurs. Additionally, as we mentioned in our Mid-Year Report Card and Outlook, rebalancing back into stocks is a good idea given performance year to date.

If you would like to discuss how inflation is impacting your investment or retirement plan, we would be happy to schedule a brief call. Simply schedule an intro call to get started.