Source: Bloomberg

Why is Inflation Still High, and Why has the Fed not Eased off Hiking?

Inflation is the key driver of the Fed’s path forward. Federal Reserve Chairman Jerome Powell has continued to reiterate his commitment to bringing down inflation, and has been using a framework that breaks inflation into three buckets: Goods, Housing/Shelter, and Core Services Ex Housing. Goods inflation has come down, and housing-related inflation should begin to decline soon. Core Services Ex Housing represents more than 50% of the core inflation index and is now the main concern. In Chart 2, you will notice Core Services Ex Housing inflation is still running at more than 6% year over year. This bucket is mainly driven by wage growth and is a large contributing factor to the Fed continuing its hiking campaign. The Fed needs to see continuous disinflation in wage growth to be comfortable pausing its rate hiking campaign, so it’s wise to keep a eye on the labor market—especially wage growth.

Chart 2: CPI Core Services Ex Housing (in %)

Source: Bloomberg

The latest nonfarm payroll report from 3/10/23 does not make the Fed’s job any easier. There was a net increase of 311,000 jobs—much higher than economists’ expectation of 225,000. The labor market is very strong with an unemployment rate of 3.6%. The average hourly earnings and the Atlanta Fed’s Wage Growth Tracker, two key indicators of wage growth, show growth still above normal levels (Chart 3), which leads us to believe that the Fed will continue to remain diligent in its effort to bring down inflation.

Chart 3: Wage Growth (in %)

Source: Bloomberg

What’s the Over/Under?

Better safe than sorry? It is likely that the Fed may overtighten in the process of cooling down the job market and push the U.S. economy into a recession. The Fed is aware of the lagging nature of labor-market indicators and monetary actions, but according to comments from Chairman Powell and other members of the Federal Open Market Committee (FOMC), the risks associated with under tightening seem to be greater than those of overtightening. If the Fed overtightens with inflation and wage growth under control, it can use its typical approach of easing monetary policy to facilitate economic recovery, so it is the easier path.

However, fighting against long-term high inflation is a different and much more difficult task: The economy could suffer more under long-term elevated inflation (or even stagflation) due to under tightening.

The last time the Fed had to fight hard on inflation was in the late 1970s and early 1980s. In that period, the Fed initially responded too dovish and had to re-tighten to bring down inflation, severely damaging the economy. No current FOMC members held positions back then, but they are astute students of economic history and theories and have learned from that experience. They may opt for some unpopular measures to ensure the inflation dragon is slayed.

So, What’s the Plan?

The Fed has taken historic measures to curb inflation, and we believe the Fed’s interest hikes are not quite done. A growing paycheck might sound good, but that wage pressure is what is keeping inflation high and the Fed diligent in its efforts. Since overtightening is not the worst-case scenario, we believe the Fed is erring on the side of caution. As a result, markets could remain volatile until the picture becomes clearer. In a potential higher-for-longer U.S. rates environment, it might be prudent for investors to monitor the U.S. dollar’s movement, stay flexible with their allocations, and adjust among different global asset classes in alignment with their investment goals.

Actions You Can Take Right Now

• Schedule meetings with clients to review asset allocations and reevaluate based on their goals.
  
  
• Consider tax-deferral strategies such as annuities to help clients save money amid high inflation.
  
  
• Prepare clients for market volatility and offer strategies to curb emotional investing.

For more insights from Pacific Life, visit PacificLife.com

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