If I could attend the June 15-16 Federal Open Market Committee, I would ask the voting members what are they trying to accomplish. Based on efforts to help the economy recover and boost general inflation, aggressive monetary accommodation has resulted in more general inflation than any reasonable person would have expected. Is it still appropriate to call the uptick in consumer price inflation "transitory?" Also, easy money has helped fuel the record surge in the market valuations of tangible and financial assets. When does financial stability become paramount to everything else?
Inflation & Risks
General inflation measured by the consumer price index has increased 5%, the largest increase since 2008. And the core consumer price index, something policymakers focus on primarily, has jumped 3.8%, the most significant increase in 30 years.
Those policymakers who think the sharp uptick in consumer price inflation is "transitory" should look at the May producer price report. According to the Bureau of Labor Statistics, final demand prices rose 0.8% last month. The goods and services split were noteworthy; goods prices rose 1.5% and service prices 0.6%. In the past twelve months, final demand prices at the producer level have jumped 6.6%, goods 10.5%, and services 4.5%
Additional increases in final goods prices will flow from the sharp rise in intermediate prices. In May, core intermediate prices rose 2.3% and 17.4% in the past year. That's the most significant increase since the early 1970s. Yet, it might be the service side with the biggest upside as that sector has the most pent-up demand.
In addition to general inflation, easy money has sparked a dramatic increase in house prices. In the past twelve months, house prices increased 20%, far more in any single year in the post-war period. Also, the gain was twice as much of any year during the housing bubble of the 2000s. At what price does housing pose the same risks as 2008?
As striking as the increases are in general consumer and producer inflation, they pale compared to equity asset inflation. Since 2020, the nominal value of domestic equities has increased $12.4 trillion, the biggest gain over five quarters on record. That gain excludes the sharp drop in equity values during the short and sharp decline during the pandemic. Is this sustainable?
Equity values decline during a recession and usually take years to move back to the prior cycle peaks. The $8.5 trillion loss in equity values in Q1 2020 fell in the middle of equity value declines of the previous two recessions ($7.7 trillion loss following the tech bubble and the $9.7 after the housing bubble). Still, the rapid recovery to new highs is unprecedented, fueled by record asset purchases by the Federal Reserve and the promise to keep buying assets and maintain low rates for the foreseeable future.
A reasonable person would conclude the challenges the Fed faces are far greater than when they tried to normalize official rates in 2018, which triggered a quick and sharp 25% correction in equity prices. It's difficult to predict what policymakers will decide to do at the June 15-16 FOMC meeting. It is even more challenging to predict how analysts will spin every word and change in the dot-plot and whether equity prices will be higher or lower when the market closes tomorrow.
But a reasonable person would conclude, "if something cannot go on forever, it won't" (Herb Stein). Thus, this reasonable person (me) would bet equity prices will be lower in six months, perhaps even more so in twelve. And even though this reasonable person (me) still thinks inflation will prove to be more persistent than temporary, financial risks remain the biggest challenge to the Fed and the economy.