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How will the Fed tackle the inflation debate?

We explore two dynamics—wages and rents—that are key to understanding its next move.

Our Top Market Takeaways for November 5, 2021.

Markets in a minute
New highs and a central bank bonanza

It was a new record kind of week. Heading into Friday, the S&P 500 had notched six consecutive new highs, bringing its 2021 tally to 63 (already the best year since 1995). A swathe of upbeat earnings reports and potential votes in Washington today on social spending and infrastructure added to this week’s optimism, but the Federal Reserve was undoubtedly the main event. 

After months of speculation, the Fed at its latest policy meeting made good on its move to start tapering its bond buying program (by $15 billion per month). All in all, the process is expected to continue through mid-2022, but Chair Powell was clear that tapering isn’t on autopilot—and can be dialed up or down pending economic conditions. For all the hubbub earlier in the year, the price reaction was far from a taper tantrum—the U.S. yield curve is only modestly steeper than it was a week ago.

Some might worry that the start of tapering means rate hikes are just around the corner. Have no fear: Powell took care to stress patience, and to distinguish tapering and rate hikes as distinct policy tools. That said, the market is currently pricing in two hikes by the end of 2022 and three more in 2023. We think the first hike will come around the end of next year, but we acknowledge there is tremendous uncertainty around the exact time of liftoff. We would take the under on the market’s expectation for five hikes by the end of 2023.

Much of that view has to do with the path of the employment recovery and future inflation. Which is exactly why we’re taking stock of the debate today.


Revisiting the (heated) inflation debate

Supply chain–related inflation has stolen all the attention. And while it’s proved stickier than anticipated, we (and the Fed) still expect it’ll cool into mid-next year as soaring demand moderates and supply incrementally comes back online. But for all the focus, such dynamics aren’t as important for the economic cycle.

What’s more important—and what drives the bulk of inflation moves over the economic cycle—are labor market dynamics (which are growing tighter) and shelter inflation (which has started to gain steam).

These two dynamics are key to understanding the Fed’s next step. Let’s take each in turn.

Key pillar of inflation #1: Labor market slack (“help wanted!”)

Today’s jobs report showed the U.S. economy added another 531,000 jobs in October and the unemployment rate fell to 4.6% (both well ahead of expectations).  But, there are still about 8 million fewer workers today than the pre-COVID trend suggests.

Let’s talk about those who have left the labor force. There are a number of different types of workers in this bucket, but it’s those who are most likely to return to the labor force who matter most for the future path of policy. For these folks, it’s all about wages—if companies pay enough, it’s probable such workers will come off the sidelines.

Digging deeper, labor force dropouts have been most concentrated in 1) females, and 2) lower-skilled workers. Together, we think these two categories will add two million workers back into the labor force by the end of next year. Retirees (~1.5 million) have played a hand in labor force dropouts too, but it’s difficult to bank on these individuals rejoining the workforce.

In the case of female workers, research has shown childcare duties disproportionately fall to women. While it’s still too early to fairly assess whether school reopening has helped to boost labor supply, we’re optimistic this dynamic, combined with the power of vaccines and rising wages, should entice women to re-enter the workforce.

As for lower-skilled workers, most tend to work in industries that were competing with the government’s enhanced unemployment benefits. Now, the industries with the lowest wages are seeing the highest quit rates (i.e., workers who voluntarily leave their jobs to find new/better ones). This is driving wages in these industries higher. Take, for instance, the fact that average hourly earnings in leisure are up 14% this year (annualized) compared to finance’s 4%.

Now for those cashing in more from unemployment benefits than in their old jobs.

The bulk of federal pandemic unemployment benefits just expired in September, and though it’s still in the early innings, there are some signs expiration has improved the probability of unemployed workers finding jobs.

To be fair, we don’t expect all these workers to rush back at once, but savings can only last so long. While there’s been a stunning $2.5 trillion in excess cash saved since the pandemic began, $1.6 trillion of that is sitting in the hands of the top 20% households by income. That leaves $900 billion in the pockets of the remaining 80%. And for this 80%, their cash on hand amounts to less than three months of after-tax pay.

Key driver of inflation #2: shelter prices (“but house prices are soaring!”)

The largest (and stickiest) component of inflation is shelter, representing around 20% of core PCE (the Fed’s preferred inflation gauge). As the economy improves, more people get jobs and earn higher wages, and shelter inflation tends to accelerate.

Shelter inflation is dominated by two components: owners’ equivalent rent (OER for short) and rental inflation.

But importantly, home price appreciation does not equal OER. House prices are an asset, a purchase that many Americans make only once in their lifetimes. OER is basically the amount of rent that would have to be paid to rent out a currently owned home. And the correlation between the two is pretty weak:

And while we’re at it, market rents do not equal actual rents the average person pays. Headlines love to quote Zillow market rents—which can be pretty misleading. Zillow only accounts for new leases, while actual rent inflation solves for all outstanding leases (both new and current).

What this all means

While headlines around supply chain–related inflation are all the rage, sustainable forms of inflation—wages and rents—matter a lot more for the Fed, and by extension, the cycle. We remain optimistic that expiring unemployment benefits, modest cash balances at the lower income cohorts, falling COVID cases, and the back-to-school transition should incentivize workers to go back to work. In the meantime, shelter inflation is likely to continue to rise, but at a healthy clip in line with an economic expansion.

As “transitory” inflation forces cool and sustainable forms of inflation recover, we expect price increases to normalize back toward 2% by the end of next year—just about in line with when we expect the Fed’s liftoff.

All market and economic data as of October 2021 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.


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