Wage-price spiral could extend risk of inflation
‘Excessively easy money’ has fueled higher costsJanuary 27th, 2022
Trillions of dollars in new central bank and federal government stimulus added to an economy already recovering from the lockdown-induced stupor of COVID-19-produced skyrocketing corporate profits and a hat trick for equity investors in 2021.
Near 29% returns on blue chip stocks was not our base case a year ago, but then again, we also did not foresee the extended duration of the Fed’s largesse. While boosting aggregate demand and corporate pricing power, excessively easy money is now contributing to headline inflation readings the magnitude of which we have not witnessed in 40 years.
Last year’s surge in more volatile energy, food, and vehicle pricing that drove such high rates of inflation is unlikely to persist in 2022 as “base effects” fade and supply chains normalize. For example, the big rebound in oil and gas prices compared to COVID pandemic lows in 2020 will not be repeated this year, nor will the price spikes for new and used vehicles as bottlenecks in semiconductor production become less of a gating factor for auto production.
The more meaningful risk is that increasingly tight labor markets boost wages to the extent that companies seeking to preserve profit margins raise prices too much, resulting in an enduring wage-price spiral that keeps inflation uncomfortably above the central bank’s 2% target.
Telltale signs are hard to miss, particularly for lower wage positions in hospitality and leisure. Whether it is the Davenport trying to hire hotel maintenance staff, the local Amazon distribution center attempting to add logistics labor, or restaurants struggling to maintain regular hours amid a shortage of cooks and servers, the response in almost all cases has been businesses boosting wages to attract workers.
With inflation substantially above targeted levels and unemployment below 4%, central bankers now recognize inflation’s threat and conclude that the economy is at or near full employment. Accordingly, the Federal Reserve has begun removing policy stimulus by reducing its program of quantitative easing.
If the Jerome Powell-led Fed was a Superman, saving-the-day bond buyer before, it is now Clark Kent shedding its cape and donning more ordinary attire as it attempts to blunt price increases. With stimulus waning, we don’t expect inflation to be the kryptonite that dooms current economic expansion.
Once the Fed concludes quantitative easing this spring, we expect it to begin raising short-term interest rates from near zero, with the key Federal Funds rate likely to be at or near 1% by year-end. In tandem, consumer rates on credit cards, car loans, and home equity lines of credit will go up, helping slow demand for the “stuff” that has contributed to above-average inflation.
Perhaps more importantly than aggregate demand is what happens to the factors of production, namely labor supply. We expect labor force participation rates to inch upward as those currently unemployed by choice diminish their recent stash of savings and return to a job market offering more attractive pay and benefits. Job growth therein should help take the edge off wage inflation, at the same time, companies investing in labor-saving capital equipment drive the next leg of productivity growth.
For now, U.S. consumers are increasingly vaccinated, employed, and asset rich from the boom in house prices and retirement accounts. Accordingly, earned income and the wealth effect should support their spending and help advance the U.S. economy despite a less accommodative Fed. In sum, we expect a nascent economic expansion to continue at slower rates of growth in 2022.
As for the capital markets, while profit growth will likely be harder to achieve amid higher labor and supply chain costs, it is our base case in an expanding economy. Earnings expected to grow at mid-to-high single-digit levels and anticipated moderating rates of inflation should allow equities to achieve positive, albeit more volatile, returns in 2022.
In contrast, bonds continue to appear less attractive amid still low interest rates. We expect benchmark 10-year Treasury yields to rise as the Fed ends its program of quantitative easing and begins raising short-term rates, leading us to expect reduced returns for bond owners. Meanwhile, commercial real estate and less correlated assets like timber, cropland, and infrastructure provide attractive investment alternatives that can help replace a portion of the income that bonds used to provide.
Hang on to your New Year’s party hats; if the early days of 2022 are any indication, this year will likely be a more tumultuous one for investors.
Shawn Narancich, a chartered financial analyst, is executive vice president of equity research and portfolio management with Ferguson Wellman Capital Management, which serves individual and institutional clients throughout the West. The company has offices in Bellevue and Portland and currently manages assets valued at $100 million in the Spokane area.