By: Russ Kamp, Managing Director, Ryan ALM, Inc.
The CPI-U was published today. Market forecasters had anticipated that inflation would continue to rise, and they estimated that the 12-month annualized inflation # would be 8.8%. They got the direction right, but the magnitude was clearly wrong as the number posted was 9.1% That reading is the highest annual inflation registered since October 1981, which happens to coincide with the month that I entered this industry. Quite surprisingly, equity and bond markets have recovered losses since the announcement this morning and they are now registering gains on the day.
Does this make sense? I guess it might if you believed that the Fed has already accomplished its objective of taming inflation by having increased the Fed Funds Rate by 1.5% and that today’s # is actually a peak. It also might be that today’s number will force the Fed to be more aggressive in its fight against inflation by raising rates perhaps by a full 1% at the end of this month like Canada just did, which will force the US economy into recession. But what is the likelihood that the Fed has achieved its goal by raising rates by only 1.5%? Furthermore, do interest rate increases drive economies into recession overnight? Does inflation evaporate immediately when interest rates are increased? I would suggest that the answers are NO, NO, and NO!!
Perhaps a little context is necessary. Let’s look back at the last inflationary environment of the 1970s into the early ’80s. In December of 1972, the CPI for the previous 12 months was 3.2%. Two months later the annual CPI # had crept up to 3.86%. It would be a full decade later until the annual CPI once again had a 3 before the decimal place. You see, inflation doesn’t rocket skyward only to fall back to earth once the Fed begins to raise rates. For those of you that didn’t live through that period let alone work in this industry, inflation would go through two periods of significant increases before falling to levels to which we all became accustomed.
It took 23 months from the bottom of the inflation cycle in December 1972 (3.16%) to the first peak (11.13% in November 1974). From there inflation began to taper as the Fed raised rates, but the bottom for annual inflation would only fall to 4.5% in November 1976, a full 1.34% above the previous low for the cycle. Regrettably, the Federal Reserve took its foot off the pedal of increasing rates and the result was a rapid increase in inflation to 13.46% in March 1980. It would be another 2 3/4 years before inflation returned to a level below 4%. For the decade ending December 1982, the CPI averaged an annual rate of 8.68%. At no point did inflation begin and end on a dime despite aggressive attempts by the Federal Reserve to combat inflation through interest rate increases.
For investors believing that rate increases will have a dramatic and immediate impact on inflation and the economy, I encourage you to please look to the 1970s as a guide. It won’t likely play out as you are hoping. Inflation may still go higher. In this environment, why would anyone want to own long bonds (30-year US Treasury Bond) with a current yield of 3.08% for a real return of negative 6%? Bond yields have provided investors with a roughly 2% real yield advantage (inflation premium) relative to the CPI throughout time. Remember, it took from February 1973 (CPI 3.86%) to December 1982 (CPI 3.5%) for inflation to get controlled. Even at 3.5% inflation, the real return to bonds is negative. Since when are investors willing to live with such meager returns?