Inflation and the State of the Labor Market

After years of muted inflation, April’s spike was a stark reminder to investors that investment risk isn’t limited to volatility and loss of principal. FDIC-insured bank balances paying out 0.5% (in online savings accounts like Ally) or 10-year Treasury notes paying 1.58% may be guaranteed to not lose money, but 2.5% inflation for just a couple of years will erode the value of your money faster than the interest can replenish it. Starting with $10,000, the purchasing power of your 10-year notes will fall to about $9,830 and your bank account to $9,620 over two years… and that’s assuming you reinvest the interest. Did your grandparents ever talk about how a loaf of bread was five cents and the milkman would drop off fresh bottles of milk for 10 cents each? That’s inflation at work, and it highlights the importance of purchasing power risk.

Whether we start to see a trend of inflated inflation, or it is in fact just transitory like the Federal Reserve and many economists believe (or hope), we do know one thing. The Fed’s revised monetary policy framework seeks to anchor longer-term inflation rates at 2%, and following periods of sub-2% inflation, “appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time”. I think it’s pretty unlikely that the Fed would allow sustained inflation much higher than 3%, but somewhere between 2% - 3% is a reasonable mid-term range we should all be prepared for. Maybe not imminently, but in the relatively near future.

This week, the Fed announced that it will start selling assets from its Secondary Market Corporate Credit Facility (SMCCF), created in the early stages of the pandemic to support the corporate bond market by encouraging bank lending to companies and ensuring liquidity in the secondary market. You can learn more about the SMCCF here. Unwinding the SMCCF isn’t bearish per se, but it does indicate a less accommodative monetary policy stance as the pandemic winds down and the economy recovers.

May’s ADP Jobs Report came in at 978,000 added jobs on Thursday, smashing the Wall Street Journal’s economist expectations survey by nearly 300,000. We’re in an interesting goldilocks situation now. “Too much” employment too fast will increase inflation fears, force the Fed to hit the brakes to prevent overheating in the economy, increase market volatility, and be a headwind to the markets. On the other hand, disappointing data like we saw with April’s jobs add would create fears of a poor recovery (with labor supply there but unwilling to work at current wage levels), and ironically, also increase inflation fears. Wages would likely rise to reduce the labor supply/demand gap and trickle to overall cost inflation. Once again, increased volatility and a headwind to markets. Don’t get me wrong, I’m here for people getting paid more and finding jobs, just stating the potential market effects here.

This brings us back to the Fed. As we watched the U.S. economy recover from The Great Recession in fits and starts, the Fed’s monetary policy stance was top of mind for investors, economists, financial professionals, and many others. The timeline of QE tapering, interest rate hikes, and general hawkishness from the Fed was critical (if literally one word changed between FOMC statements, financial media was making inferences about the Fed’s changing stance). So what’s the post-pandemic Fed’s tightening timeline? Right now, expectations seem to be that the Fed will admit to discussing tapering at their June meeting, announce an official plan to taper in late summer or early fall, and begin tapering in December this year or January next year. If May inflation comes in hot again, or the labor market recovery is stronger than expected, that timeline could be pulled earlier, which could bring substantial volatility.

As investors, what can you do in the face of higher inflation and volatility? I remain a staunch proponent of a global and diversified portfolio. Diversification within and across asset classes and geography reduces the effects of many types of risks, including inflation. Sure, inflationary pressure in the U.S. would likely have a downward effect on U.S. equities, but if inflation doesn’t manifest, getting that bet wrong and being out of the equity market could be very costly. Diversify and stay the course. It’s not glamorous like trading crypto or buying meme stonks (for the winners), but at least you won’t be betting your financial well-being on cryptic tweets and YOLO.

If you have any questions about what’s going on with the Fed and the labor market, want to discuss your risk tolerance and portfolio allocation, or want to know how much money you should throw at DOGE or BB for the memes, please don't hesitate to let me know.