The month of April saw a spike in inflation rates to 4.2%, the highest 12-month increase since September 2008. In May, inflation rose by 5%, beating the 4.7% that economists had projected. While the higher than expected print caught some economists by surprise, several had warned that recent actions by the government and the Federal Reserve would cause price increases.
Government COVID-19 Interventions
The Federal government has issued around $10 trillion in COVID-19 relief programs since March 2020. These programs include the $2.2 trillion CARES program issued in March 2020, a $900 billion program issued in December 2020, and three relief programs offered under the Biden administration amounting to over $6 trillion.
How The Fed Can Respond To Growing Inflation
There are several tools that the Fed can deploy to manage inflation before it runs out of control. These include yield curve management and strong policy guidance. However, these tools can come at a cost and can be deemed ineffective if not applied correctly.
The Federal Reserve has contended with higher inflation in recent times, but the recent unexpected price increases have prompted the finance regulator to change stance. Over the past year, the Fed has kept a blind eye on inflation signs and maintained low-interest rates and a loose monetary policy.
Impact On Markets
The latest price increases have caused fears among investors on Wall Street. However, amid these inflation fears, major market indices have remained resilient.
A June 3 trading session ended with the S&P 500 at an all-time high as investors played down an inflation report that showed more than projected inflation levels. The equity benchmark rose around 0.5% to a record closing high of 4,239.18. The Dow Jones Industrial Average rose 19.10 points to 34,466.24, while the NASDAQ Composite rose 0.8% to 14,020.33.
However, there are growing fears, especially on the stock market, that the latest jump in prices may increase the rate of interest rates hikes soon than expected and cause the Federal Reserve to introduce tougher monetary policies.
What The Fed Said
In a recent media brief after one of the Central Bank's annual meetings, Fed chair, Jerome Powell, said that the current situation is very far from the thresholds needs required to raise interest rates. Powell, in a comment on the inflation rates, noted that the current reopening of the economy would continue to cause shocks in supply and demand and other challenges like hiring constraints. These factors, according to Powell, may raise the possibility that inflation could turn to be more persistent and higher than projected “transitory” base case.
In a recent interview, Powell said Fed may not be targeting an inflation rate of 2% but admitted that maintaining that average over a long period will be healthy. In addition, he noted that the Fed's decision wouldn't entirely be based on inflation alone but on wide-ranging financial conditions.
Possible Response To Current Inflation Levels
The prevailing inflation, which is mainly attributed to the COVID-19 pandemic, is quite different from previous financial crises. It is characterized by huge imbalances between supply and demand for various goods.
The various frictions in the supply chain plus challenges in hiring have led to an increase in the prices of some goods. On the other hand, the market is dealing with growing demand for cars, trips, and other luxuries. All these factors are pushing commodity prices up. The government and monetary stimulus packages have only compounded the inflation situation.
The current times are famed as a moment of adjustments on multiple fronts, including prices of goods, demand and supply, and the labor market. The month of April saw 266,000 jobs created, much lower than earlier projected. This has been attributed to some policies adopted during the pandemic, like expanded unemployment benefits and direct cash transfer, which encouraged people not to go back to work.
Other factors that are hampering employment include an uncertain school calendar that has put pressure on parents and their flexibility to work. In addition, the continuing uncertainty about the pace and direction of the pandemic has also caused several employers to hold back on new hiring plans.
The Fed May Have To Raise Interest Rates
Earlier, Powell had pointed to tougher monetary policy if conditions do not improve. In an April letter to Florida Republican Sen. Rick Scott, Powell indicated that the Fed would intervene if inflation stayed above 2% for a long time.
In the letter, he wrote, "If progress towards our employment and inflation objectives slows, we will maintain a highly accommodative stance for longer. Conversely, if progress turns out to be more rapid, adjustments to the stance of policy would likely occur sooner."
While the Federal Reserve may have several tools at its disposal to manage inflation, it is a tough balancing act as many of these tools come at a cost to the economy. While interest rates are the most common way to control inflation, the same need to be applied with caution and in consideration with other measures.
Bryan Lee is the Chief Investment Officer at Blue Zone Wealth Advisors. Blue Zone Wealth Advisors is a wealth and investment management firm serving families and individuals in Southern California and across the United States. Headquartered in West Los Angeles, the Blue Zone team combines the intelligence of various financial disciplines under one roof to offer family office services to their clients.
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