No way out? Why the Fed may be trapped

The job gains cited in the May 2021 non-farm payrolls release fell well short of what the market had hoped. A fluke? Maybe, but this disappointing jobs report suggests to me that US inflation dynamics are beginning to shift from “demand-pull” to “cost-push” inflation.

The perils of cost-push inflation

Demand-pull inflation is the upward pressure on prices that occurs when aggregate demand outpaces aggregate supply. Cost-push inflation, by contrast, is caused by increased costs for raw materials, wages, and other inputs to production. The latter type of inflation tends to be much more harmful to an economy, as it forces companies to choose from among three distinct (and all undesirable) options:

1. Seek to cut their capital costs elsewhere to preserve profit margins
2. Invest in productivity-boosting solutions to reduce their labor costs
3. Pass their increased costs on to consumers in the form of higher prices

The most probable scenario, in my judgment, is option 3. Typically, this not only leads to broadly rising inflation for an economy, but also adversely affects economic growth in that higher inflation alters consumer behavior by blunting demand, particularly on non-essential goods and services. For example, given today’s lofty lumber prices, many households have postponed discretionary home renovations.

Bottom line: Cost-push inflation can erode corporate profit margins, eat into consumer budgets, and contribute to lower overall real growth.

Implications for monetary policy

If I am right that the US economy is entering a new phase that will be more subject to cost-push inflation, what does this mean for the future path of US monetary policy? Perhaps quite a bit.

According to the US Federal Reserve (Fed)’s revised monetary policy framework, for the Fed to raise interest rates, it will need to observe both very low unemployment and average inflation above 2% for a sustained period. The shifting inflation dynamics may test the Fed’s resolve by making its dual objectives harder to achieve. Inflation is likely going to be “stickier” than it was last cycle and the unemployment rate structurally higher, given the massive COVID response by fiscal authorities and structural changes to the labor supply.

In a nutshell, I see the Fed as being trapped by its own devices. Its new policy framework subjugates its inflation mandate to its unemployment goal, which may well be unattainable. And as noted, inflation is likely to be sticky. One troubling possibility worth considering: What if cost-push inflation starts cutting into corporate profits, causing the US stock market to begin underperforming? Then the Fed could be in an even bigger bind, where financial conditions are tightening at the same time that its employment goal remains out of reach.

Investment takeaways

• US dollar: I’ve been negative on the US dollar (USD) for a few years now and believe May’s underwhelming job gains could be a catalyst for further depreciation. I see three other reasons to be bearish on the USD: An expensive real exchange rate, rising current-account deficits, and the Fed’s new revised policy. A weaker dollar going forward could translate to relative strength in some other global currencies.
• Long-end US real yields: I don’t have a lot of conviction right now in accurately forecasting the direction of the US nominal-bond market. However, there may be an opportunity in long-end (30-year) US Treasury real yields, which I suspect could outperform their nominal-bond counterparts if (as I believe) the next upward move in US rates comes from rising inflation expectations.
• Non-US duration markets: I believe non-benchmark, total-return-oriented bond investors should scour the globe for non-US duration markets that appear to offer more compelling opportunities than the US nominal-bond market. The developed markets of Canada and Norway are two that I think are worth a look these days.
• EM local bonds: Another potentially attractive source of global duration is in emerging markets (EM) local bonds. EMs where I currently like both the rate and currency markets include Mexico, Russia, Brazil, and Indonesia.