Rising inflation expectations challenge the Fed

February’s inflation numbers, released last Thursday, March 10th, showed both the headline and core Consumer Price Index (CPI) at their highest levels since 1982. The headline inflation rate, which includes volatile food and energy prices, rose at a year-over-year rate of 7.9%. The core rate, which strips out food and energy costs, hit 6.4% over the same month last year.

The jump in overall inflation was driven by rising prices for housing, new and used vehicles, and energy. Consumers are already feeling the effects of inflation in their budgets and it’s affecting their outlook on the economy. A recent flash poll from the Nationwide Retirement Institute found that over half of consumers noticed a change in their purchasing power, especially among older consumers.

Economists continue to contend that many of the factors fueling the current bout of inflation should subside over time, though the word “transitory” seems to have faded from the conversation. The consensus among economists as measured by Factset shows an estimated CPI for 2022 of 5.2% then moderating to 2.4% in 2023. After this past week’s Federal Open Market Committee (FOMC) meeting, it seems Fed officials are getting more serious about inflation, revising their inflation estimates upward to 4.3% for this year, then easing to 2.7% in 2023 and 2.3% in 2024.

A little over two years ago, back in the pre-pandemic days, all the talk among economists and market participants focused on deflation, not inflation. Throughout the decade of the 2010s, both core and headline inflation averaged around 1.8% per year, below the Fed’s target inflation rate of 2.0%. Forward estimates of future inflation showed little sense of any concern; at the end of 2019, the Fed was forecasting an annual inflation rate of a mere 2.0% in 2022. Investor expectations had moderated as well, with the 5-year breakeven inflation rate (indicating average market expectations for inflation in the next five years) sitting at 1.6% by the end of 2019.

Things are decidedly different in 2022 for obvious reasons. The 5-year breakeven inflation rate has spiked since the beginning of the year, hitting a near 20-year high of 3.5% last Friday, March 11. (See chart above.) The pandemic induced a supply shock and shifted consumer demand from services to goods, and the resulting stress on supply chains pushed up prices for many consumer items. At the same time, fiscal and monetary stimulus, while positively supporting economic growth, boosted consumer demand, exacerbating the supply crunch, and adding further inflationary pressure to the economy. The receding impact from COVID, including the fading impact of lockdowns and the expiration of government stimulus, should help some of the demand pressures ease, but supply chain issues and input cost pressures (including wage gains) will take time to moderate.

Inflation expectations are a significant factor to watch right now and may contribute to extended periods of inflation. If businesses expect input and labor costs to climb further, they’ll respond by raising prices for end-consumer goods. As consumers face higher inflation in their purchases, they’ll demand higher wages to compensate, helping to perpetuate the inflationary trends. Reversing that cycle once it has started can be very difficult to do.

The size and complexity of the U.S. economy make changing direction much like steering an aircraft carrier. Economic shocks like the pandemic can quickly lead to disruptions but getting the economy back on course takes time. The Fed, arguably, was late in recognizing the persistent nature of inflation, maintaining its quantitative easing programs, and keeping the Fed funds rate at near-zero despite CPI being over 2.0% since last March. After previously projecting just three rate increases for 2022, the Fed now appears ready to adopt a more aggressive path of tightening monetary policy with seven total rate hikes now possible for 2022 to arrive at an estimated Fed funds rate between 1.75-2.0% by the end of this year. According to recent Fed funds futures indicators, markets see a good probability that rates will be in the 2.0-2.25% range by the FOMC’s December meeting. Increased uncertainty in response to the Russian military invasion of Ukraine adds to the difficult task ahead for central bankers as they try to keep the economy on an even keel.

Despite the volatile start to the year and the prevailing geopolitical uncertainties, we continue to believe that investors should reset their expectations for market returns, given the elevated valuations in many areas of the equity market and the pressures facing the bond market from rising interest rates. Many of the tailwinds that helped investors realize double-digit gains in recent years, even in moderate portfolios, are turning into headwinds. We anticipate a continuation of market volatility driven in large part by the emotions of investors. We also see the possibility for greater democratization of returns with a shift in market leadership from high-flying technology and growth stocks to traditionally value-oriented sectors lasting for some time.

For alternatives, investors should consider value, international and small-cap stocks, which as categories are at a significant valuation discount to large-cap growth. For income, we prefer dividend stocks, high yield bonds, and options-based strategies. Fixed annuities may also provide upside potential with downside protection, along with providing the opportunity to pick annuities with specific exposures.