Inflation has been a focal point of client conversations for the past year. And the problem has gotten worse over that time, not better. That has taken on added importance because the longer and more persistent it is, the Fed will be forced to use stronger tools to combat it.
Since the pandemic, most of the inflation we experienced was demand side inflation. We all know the story. The stimulus thrown at the economy by the Federal government along with the Federal Reserve, coupled with the unforeseen ability of U.S. corporations and businesses to pivot seamlessly to a remote work environment kept everyone at work. And because of shutdowns, spending shifted almost entirely to goods, not services. This overwhelmed (and still is) the global supply chain causing prices to move higher.
Demand side inflation can be looked at as a "good" problem. It means people have jobs and money and are spending, so the economy can tolerate it. This, along with the supply chain disruptions being seen as a temporary situation, kept the Fed in a wait and see mode rather than acting to change policy sooner.
Because it has now gone on for so long, coupled with the heartbreaking situation in Ukraine, it has become a supply side inflation problem as well. Additionally, we now have covid shutdowns in China again.
The main tool in the Fed's arsenal is interest rates. Fed officials are signaling that they will take a more aggressive approach to fighting high inflation in the coming months — actions that will make borrowing sharply more expensive for consumers and businesses and heighten risks to the economy.
Raising rates is a ham-fisted approach. It's impossible to know ahead of time what rates should be set at to slow the economy enough to quell inflation without stymieing growth leaving open the possibility of a hard landing. And they have already moved up fairly dramatically.
For instance, mortgage rates have gone from 3.5 percent to 5 percent in just six months, the fastest increase of that magnitude ever. That means the monthly payment on a median U.S. home has gone up 20 percent. Or looked at another way, if the payment were to stay the same amount it was six months ago, that same median home would need to be 16 percent cheaper. How this plays out will have broad implications.
Lastly, the Fed's policies can only effect the demand side of inflation. There is obviously nothing they can do to lower the price of copper or wheat. They can't print oil. So all eyes will be on prices in 2022, especially of commodities. And because they are very volatile, I would expect that the volatility in all markets we've been experiencing this year to continue.