There is a popular narrative coming from both political and economic pundits that, in fact, the Pandemic inflation explosion was indeed transitory as it was caused by pandemic-related supply shocks, implying that inflation had nothing to do with the Fed’s 100% increase in the money supply. It is important to note that whenever there is a massive expansion of the money supply, such as the one currently occurring in Argentina, a shortage of goods develops as there are too many dollars chasing too few goods. This shortage is not a function of supply shocks but rather a demand shock caused by massively excessive money supply expansion.
There were certain supply shocks during the Pandemic that were related to lockdowns and there was an energy price shock related to the Ukraine war. However, the majority of inflation was caused by Federal Reserve policy. The primary transmission mechanism of monetary policy is the housing sector. Moreover, the US housing sector has over 144MM homes with only approximately 1.4MM homes built during a normal year.
Consequently, the price of housing is almost exclusively determined by interest rates and the quantity of money as any minor fluctuation in housing construction has a minimal impact on the total supply of housing. The Fed’s unprecedented quantitative easing program combined with its zero interest rate policy caused 30-year mortgage rates to drop to an all-time low of 2.8%. This policy caused the Case-Shiller home price index to skyrocket from 3.5% year-over-year price increases to over 20% just one year later. This housing price explosion eventually led to the shelter component of CPI accelerating to over 9% year-over-year. Since CPI also peaked out at 9% Y/Y, and shelter represents 44% of total CPI, housing accounted for approximately 44% of total inflation. In addition, the Fed’s interest rate policy also impacts the demand for consumer durables including autos, so the Fed’s policy clearly exacerbated “supply shocks” by significantly stoking demand for goods.
It is no coincidence that after the Fed raised rates by 5.5% and shrank the monetary base by 20%, the housing market cooled off from 21% Y/Y in early 2022 to a low of negative 2% by May of 2023. In addition, the rise in rates cooled demand for autos and other consumer durables, allowing the goods market to normalize. The cooling of inflation was also aided by declining energy prices and the resolution of the auto chip shortage, both of which contributed to the highest inflation rate since the 70’s.
We continue to be optimistic about the decline in inflation as increases in the money supply and energy price shocks are the critical causes of excessive inflation and both of those factors indicate declining inflation with the money supply off more than 15% from its highs and energy prices off 40% from the high of $130/barrel. In addition, PCE Core inflation is set to roll down rapidly to less than 2.5% over the next three months as we anniversary very high inflation numbers in the 1st quarter of 2023. Also, the reported PCE Core number is artificially inflated by the highly lagged shelter component of PCE.
The Federal Reserve is very likely to cut short-term rates in May or June of this year in response to the PCE Core plunging very close to its arbitrary 2% target. These rate cuts, combined with global rate cuts from the ECB and other OECD central banks are very likely to cause long-term global interest rates to decline rapidly, propelling both stock and bond prices higher. Our 2024 target on the S&P 500 remains at 5,500 with risk to the upside and our target for the US 10-year treasury is 3.25%. In this environment, we believe financials, REITs, small-cap stocks, and preferred stocks are likely to outperform the market.