Webcast #3 - What was the US FED thinking?

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Full script:

Good day, ladies and gentlemen!

Welcome to our Singapore Macro Strategist channel!

Our webcast topic today is, “What was the US FED thinking?”.  We will be analyzing the recent FED actions and statements to give our opinions on the current situation.

Many analysts and FED governors are giving ambivalent statements about the current inflation which are befuddling the ordinary people.  Let’s take a look at these statements now.

The US Fed Powell had stated clearly that he won’t raise the benchmark rates (0% to 0.25%) on fear of inflation and the US Treasury Secretary (Yellen) had proclaimed that the current inflation would be lowered to 2% by year-end.  However, other FED officials had stated that the transitory inflation might last longer and Bank of America had projected that the inflation would last up to 4 years.

Why were there such contradictory statements?

What was the US FED thinking?

Let’s put ourselves in the FED’s shoes now so that we can understand the rationale behind the FED’s statements.

How did the US FED reach the conclusion that inflation was transitory in the first place?

The proximate causes for the “transitory” inflation were temporary problems such as supply chain issues and inventory shortages that could be resolved in a matter of months.  The profit-oriented companies involved in these problematic situations would try to resolve such temporary problems as soon as possible so that their profitabilities would not be affected.

As we can see on the chart, the commodity PPI had stopped rising but consumer inflation still lagged behind the PPI.  Therefore, there was not much room left for consumer inflation to trend higher.

Let’s take a look at copper and lumber which are commonly used raw materials.  The copper and lumber price charts showed that their prices had been falling recently.  Furthermore, the supplier delivery times had peaked and looked set to trend lower.  Simultaneously, the business inventories-to-sales ratio was also approaching its trough and would rebound soon to ease the inventory shortages.

Therefore, all these economic turnaround signals boosted the FED confidence that the current high inflation won’t be persistent.

Although the US FED had pronounced that it won’t raise its benchmark rates, it did raise its i-o-e-r and RRP rates recently which were still within the benchmark band limits.  Please watch our previous video if you are interested to find out more.

Thus, the US FED’s actions contradict itself and show that there is something more to this than meets the eye.  In fact, the FED has shown that it is trapped between a rock and a hard place because it is being held hostage by the market.  In a nutshell, the FED is treading on a thin rope that requires careful calibrations and the FED cannot raise its benchmark rates soon.

What stressing problems are the FED facing now?

First of all, the US stock market is at an all-time high because of the US stimulus.  Simultaneously, the US households’ equity allocation is also at an all-time high.  Therefore, any rate hike will cause a stock market correction or crash that will devastate the wealth of many US families.

The growth in the US total market capitalization (denominator) has exceeded the growth in the FED balance sheet (numerator) as shown on the chart and this makes the percentage of the FED assets fall below the mean.  However, there is not much room for the FED asset purchases to increase further because there is excess liquidity in the financial system already.  Thus, the US total market capitalization is likely to shrink with the diminishing FED asset purchases.  Consequently, the unwinding of the FED assets or QE tapering will exacerbate the fall in the stock market.  Thus, the US FED will also be very prudent on its QE tapering program.

Moreover, the US FED does not want to cause extreme fear in the stock market by either making risky deliberation over the QE tapering or hiking its rates because there are already some fears in the market.

Next, the low-interest rate policy and QE program are encouraging zombie companies to stay afloat by issuing risky junk-rated bonds at a record pace.  Therefore, the US FED cannot increase its rates as it will create serious repercussions in the debt market.

The burgeoning growth in public (Federal) and private debts are detrimental to the GDP growth because rising debts will result in profligate and unproductive investments.  We can see such inverse relationship effects on the debt versus GDP growth charts.

In view of this, the US FED is expected to conduct a contractionary policy next year to reduce excessive liquidity and profligate investments.

The recently reported core PCE inflation of 3.4% has shown that the current inflation is a real and present danger as it is the 2nd month to exceed 3% this year.

As stated in our previous video, the current inflation was caused primarily by significant price rises in used vehicles and airfares.

So, what will cause the current inflation to persist?

We believe that the property sector, crude oil & freight, pent-up demand, and employment cost will provide the oomphs for the current inflation to continue.  

Let’s take a look at these 4 factors in detail.

The new home sales and prices had been rising significantly since 2020 but the CPI had not been affected much by them.  However, we believe that the backlog of home orders will continue to sustain the property prices and rentals even though the property sales will moderate due to a mismatch of demand and supply.  Simultaneously, the existing home price had been trending up with double digits gains since 2020.

The next chart will show the home builder and home buyer sentiments with the huge divergence that will affect the property sales.

The huge divergence in sentiments has already begun to cool down the property transactions.  This can be seen in the decline in mortgage purchase applications.

The 2nd factor that will sustain inflation will be the rising crude oil price and high freight cost.

The crude oil had surpassed its recent peak recently (around US$75 now) as indicated on the chart.  Furthermore, Bank of America had predicted that the Brent Crude could reach US$100 next year.  Some analysts also predicted that crude oil could reach as high as US$130 in the future.  Therefore, the freight cost will still be able to sustain its high price as crude oil price rises.

Next, President Biden had raised the US minimum wage to US$15 from US$7.50 and this new wage policy would become mandatory after March 2022.  President Biden had already raised the minimum wage for federal contractors.  Therefore, we expect the employment cost in the private sector to go up accordingly which will sustain the inflation.  In reality, the private sector had already started to increase the workers’ wages because many businesses had difficulties finding workers.  We could see this from the jobs opening which had reached almost 9.3m positions in April 2021.  Therefore, there is a huge mismatch in the job applicants and jobs now.

Last but not least, the reopening of the US economy will unleash the pent-up demands which will sustain inflation.  The US consumers have high savings now because of the pandemic and they are ready to spend when the economy reopens fully.  The personal savings rate chart showed that the US was still having a high savings rate that was way above its mean.

Now that we have established the confluence of inflationary factors, let’s try to determine the veracity of Yellen’s projection of the year-end inflation of 2%.

The recent consumer inflation expectation for May 2021 rose again and this meant that the consumers expected the year-ahead inflation to be about 4%.  This consumer inflation expectation had been above 3% since January 2021.  Furthermore, Bank of America had already indicated that many S&P 500 companies were already concerned about US inflation.

Therefore, we find Yellen’s projection too unrealistic and we predict that the year-end inflation to be around 3%.  On the other hand, if Yellen manages to remove the US-China tariffs in Q3 2021, then it is possible for the year-end inflation to reach around 2%.  We had already stated this possibility in our first video.

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