Federal Reserve Chairman Jerome Powell has made some interesting statements in recent weeks about the Fed’s view of inflation. In summary, Chairman Powell has stated that overall inflation remains below the Fed’s 2% long-term objective, and that while reopening of the economy could produce price increases later in the year, inflationary pressures from rising prices are likely to be neither large nor persistent. Given the transient nature of these effects, and a long history of deflationary pressures in the U.S. and around the world, Chairman Powell believes that inflation isn’t something to worry about. And in any event, Chairman Powell reassures us that the Fed “has the tools to deal with that [inflation]” should it rise above long-term target levels.
These statements stand in increasingly sharp contrast to the real world in which ordinary Americans live. The phrase popularized by Mark Twain that there are “lies, damned lies, and statistics,” seems well-suited to the Fed’s use of the Consumer Price Index (CPI) as the primary yardstick for inflation. The index has seen many changes to its basket over the years, which some believe has the effect of reducing measured inflation. The index is also targeted at urban consumers, and thereby tends to underestimate the actual cost of living as experienced by the majority of American suburban and rural consumers. A good example of this is housing costs, which were flat or declining in 2020 in large urban areas like New York and San Francisco and rising rapidly everywhere else. This past year saw urban dwellers flee densely populated areas that had more aggressive lockdowns and other restrictions related to the pandemic, and what felt like an increasingly unsafe public space within many of our cities. There is a disconnect between what the Fed is portraying and the reality of life on the ground.
Indeed, most Americans are seeing substantial increases in their actual cost of living that belie both Powell’s statements and the Fed’s data. To illustrate this, it’s useful to look at a few specific products. Gas and diesel, for example, were up 13% and 15% on an annual basis in February, with overall energy costs up 6%. Wholesale grains and meats were also up over 6% and 5% each. In 2020, at-home food prices rose 3.5%, nearly 75% higher than the 20-year average annual increase, while the cost of meats increased by 6% to 10% depending on the category. This puts a particular burden on lower-income families, which spend an average of 35% of their income on groceries, and forces substitution into lower quality (and lower protein) products.
Housing costs are also rising. U.S. home prices have increased over 11%, the fastest pace since the bubble that led to the global financial crisis, making it more difficult for first-time buyers and others with steady but flat income. On a related note, the cost of softwood lumber, the essential commodity for homebuilding, has doubled over the past year.
Rising commodity and other prices would matter less if American incomes were growing apace. But unfortunately, this is not the case, other than at the very top. While household incomes were rising robustly across the board in 2018 and 2019, the shutdown of the economy in 2020 put the brakes on further gains (excluding one-off COVID-19 relief disbursements) and exacerbated the existing trends of rising income inequality. Those who gained the most in 2020 are the wealthy, who by and large are benefitting from financial asset bubbles rather than increased productivity from (or reward for) their labor. They are also the ones least likely to feel the impact of rising prices at the pump and at grocery store. But for most working- and middle-class Americans, not feeling enriched by Bitcoin and Tesla, the pressure is beginning to build.
Financial asset prices are already reflecting rising inflation expectations well above what the Fed’s data or long-term targets would suggest. Pricing pressures are likely to continue to accelerate throughout 2021 as the economy reopens and consumer demand increases for both products and services such as travel, entertainment, and hospitality, those sectors most impacted by the restrictions. This is likely to continue to provide bullish momentum for food, energy, and other commodities. To the extent that inflation expectations “embed” in the mind of Americans, we can expect to see velocity of money increase, and the shift into real estate and other hard assets continue, to the detriment of bonds and cash.
At the same time, the massive and unprecedented fiscal stimulus being put forward by the Biden administration will clearly be pro-inflationary in ways that we cannot easily predict, other than to confirm that it will hit the middle-class hard. As unemployment falls and growth in demand starts to pressure wages, we can expect to see greater inflationary forces take hold. Already by February, over half of the states had unemployment rates below 5.5%, with 20% of states below 4%. These rates are highly correlated to the state’s policies on lockdowns and reopening. As the larger, more restrictive states such as New York and California eventually reopen, inflationary pressure will likely increase from demand stimulus.
Lower unemployment, accompanied by rising wages and income, would be welcomed over the short term. I am, however, much less convinced than Chairman Powell seems to be of inflation’s transitory nature, or of the Fed’s ability to control the inflation genie once it’s out of its bottle.