Why You Shouldn’t Expect A Return To 2% Inflation

Jamie Dimon thinks the Fed may tighten rates six or seven times this year. Bill Ackman believes the Fed should punctuate the start of the tightening cycle with a 50bp hike in order to regain some credibility. Whatever their self-image, this is a dovish FOMC. Central bank bond buying is set to continue until March, and raising short term rates can only start then. So monetary stimulus continues, in the interests of avoiding any surprises. An unemployment rate of 3.9% combined with hourly earnings increasing at a 7.5% annualized rate (December was up 19 cents to $31.31) reflects full employment. They’re already late.

Cyclical peaks in short term rates have declined over the past couple of decades. It seems the economy succumbs to monetary tightening more readily each time. This is why the market doesn’t expect rates to move much above 2%, and is probably why the Fed is so lethargic in normalizing policy. They don’t expect to tighten much.

Over the next year, the risks seem skewed to the upside for rates. Fed chair Jay Powell continues to blame goods shortages for inflation, even though labor is most clearly under-supplied. FOMC forecasts of inflation have been steadily increasing. A 2% rate cycle peak with the economy booming and the Fed still stimulating seems optimistic. Eurodollar futures have been pricing in less optimism recently, but surely need to at least match FOMC projections in order to stop offering an asymmetric bet.

Looking farther out, ten year inflation expectations at 2.5% invite one to wager on higher. Although Jamie Dimon’s warning of more aggressive tightening looks prescient, we only reached this point because of the FOMC’s dovish posture. Reducing inflation from 7% draws little debate; bringing it down from 4% to 3%, and eventually to their long run 2% target, is likely to provoke concern about unnecessarily costing jobs. The Fed has taken excessive inflation risk to achieve today’s full employment – they clearly interpret their dual mandate as weighted towards people over bonds.

This is not necessarily bad. Monetary orthodoxy has long held that 2% inflation maximizes employment, but that could change. America’s indebtedness is relentlessly up. Expect more thoughtful pieces arguing that a little higher inflation eases the burden of debt service by providing more room for negative real rates. It is the endless gift from investors who must own bonds to those who service them — US taxpayers. We should take advantage of it.

There are in any case ways for the Fed to overlook certain elements of inflation. Owners’ Equivalent Rent (OER) is one. This flawed survey of what homeowners believe their home would rent for continues to show the cost of shelter to be only inconsequentially rising, in complete defiance of the buoyant real estate market the rest of us see. Since the July 2006 peak in housing OER and the Case Shiller index, which actually measures home prices, have recorded similar increases albeit along very different paths.

OER is lagging housing prices by over 15% year-on-year but has belatedly begun to reflect the housing market since its annual rate of increase has risen from 2% in April to 3.8% now. This suggests OER is set to inconveniently accelerate just when the FOMC strategy of hope is supposed to be working. But since OER is the only non-cash item in the inflation statistics, it wouldn’t take much for the Fed to dismiss its message since nobody writes a monthly rent check linked to OER.

The energy transition is another example. Shifting to a lower carbon energy system is going to raise prices – obviously, or we’d already be there. The inflation that counts usually excludes food and energy, because they’re volatile. But Europe’s energy crisis shows what excessive reliance on windmills and policy aligned with Greta soundbites can deliver.

ECB member Isabel Schnabel recently warned that Europe’s transition to cleaner energy presented upside risks to their inflation target. US states have generally avoided the worst of Europe’s policy errors but won’t be immune to rising global demand for coal, natural gas and oil. Investments in new production remain well behind what most analysts believe is necessary to meet emerging economies’ increasing living standards, and energy sector growth capex will remain constrained by caution around public policy.

If inflation is elevated due to the energy transition, tighter monetary policy need not follow. Although the energy value of a British Thermal Unit (BTU) is fixed, officials could conclude that greener BTUs are more desirable. It’s similar to the numerous quality adjustments statisticians at the Bureau of Labor Statistics make, which lower stated inflation. Successive iPhones are more expensive, but their added features represent improved quality. Since inflation measures the cost of a basket of goods and services of constant utility, this approach records falling prices for most consumer electronics even if the consumer winds up paying more. The same approach could be used for energy, in that the BLS could assess a quality improvement to energy delivered with reduced emissions, muting its actual increased cost.

The bottom line is that investors over the next year or so should consider the risks of a more hawkish Fed. But over a longer timeframe, the impact of sustained 3-4% inflation on portfolios warrants more attention. It’s likely to be the path of least resistance.

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

Print Friendly, PDF & Email

Important Disclosures

The information provided is for informational purposes only and investors should determine for themselves whether a particular service, security or product is suitable for their investment needs. The information contained herein is not complete, may not be current, is subject to change, and is subject to, and qualified in its entirety by, the more complete disclosures, risk factors and other terms that are contained in the disclosure, prospectus, and offering. Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. No representation is made with respect to the accuracy,  completeness or timeliness of this information. Nothing provided on this site constitutes tax advice. Individuals should seek the advice of their own tax advisor for specific information regarding tax consequences of investments.  Investments in securities entail risk and are not suitable for all investors. This site is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and do not reflect the deduction of the advisor’s fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase. Indexes and benchmarks may not directly correlate or only partially relate to portfolios managed by SL Advisors as they have different underlying investments and may use different strategies or have different objectives than portfolios managed by SL Advisors (e.g. The Alerian index is a group MLP securities in the oil and gas industries. Portfolios may not include the same investments that are included in the Alerian Index. The S & P Index does not directly relate to investment strategies managed by SL Advisers.)

This site may contain forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involves a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of SL Advisors LLC or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made. r

Certain hyperlinks or referenced websites on the Site, if any, are for your convenience and forward you to third parties’ websites, which generally are recognized by their top level domain name. Any descriptions of, references to, or links to other products, publications or services does not constitute an endorsement, authorization, sponsorship by or affiliation with SL Advisors LLC with respect to any linked site or its sponsor, unless expressly stated by SL Advisors LLC. Any such information, products or sites have not necessarily been reviewed by SL Advisors LLC and are provided or maintained by third parties over whom SL Advisors LLC exercise no control. SL Advisors LLC expressly disclaim any responsibility for the content, the accuracy of the information, and/or quality of products or services provided by or advertised on these third-party sites.

All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client’s investment portfolio.

Past performance of the American Energy Independence Index is not indicative of future returns.

Print Friendly, PDF & Email
0 replies

Leave a Reply

Want to join the discussion?
Feel free to contribute!

Leave a Reply

Your email address will not be published.

This site uses Akismet to reduce spam. Learn how your comment data is processed.