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Inflation is Sticky

Inflation is Sticky

In 1963, economist Milton Friedman instructed that “Inflation is always and everywhere a monetary phenomenon”. That line has become famous over the years for its simple way of explaining the occurrence of inflation. Not every economist agrees with Mr. Friedman on this, but we do believe it is fundamentally correct.

Looking back at our inflation history, we can see that in March 2021, the Consumer Price Index (CPI) reading was 2.6%, the first time in a long time that CPI went above the Federal Reserve Bank (Fed) target of 2.0%. These readings are associated with the amount of inflation over the past 12 months. Inflation continued to rise after that, to a peak of 9.1% in June 2022. Inflation started trending down after that until December 2023, when inflation seemed to stall.

In 2024, the readings have been disappointing, with the CPI coming in at 3.1% in January, 3.2% in February, and then 3.5% in March. In December 2023, many analysts believed we would see the first Fed rate cut in March 2024. Then the January CPI came in, and the story shifted to a first rate reduction in May. Then February CPI came in, and the story shifted again to a June first rate reduction. Then, the March CPI came in and was very disappointing. The story is now shifting again from the June first rate reduction to something later. There is even some talk about the possibility of raising interest rates again. The logic is that considering that rates have been at the current level since July 2023, and if that isn’t enough time to push inflation down, then perhaps the rate needs to be higher. A rate increase is not fully accepted by the Fed or the markets, but it is a possibility that we cannot ignore. The point here is that inflation is much stickier than many expected, and we are not effectively moving toward the 2.0% CPI Fed target, at least not yet.

How Did We Get Here?

Going back to Mr. Friedman’s instruction, we feel his words help us understand the recent wave of inflation we’ve seen since March 2021. If you consider Mr. Friedman’s guidance, then you can extrapolate it to understand that inflation comes when you have an imbalance in the forces of supply and demand. And that, we believe, is the driver of the current inflation situation. 

Going back into the years of the COVID-19 pandemic, we see unprecedented levels of government stimulus. Starting in March 2020 (the month COVID 19 was first referred to as a pandemic) the first round of stimulus started. A second round happened later that year in December. A third and final round was done in March 2021. The three stimulus payments totaled over $5 trillion. This is a huge slug of money for any economy to absorb. We believe this combined stimulus was a big part of a large increase in demand in the economy. 

Think about it, the extra money sent to both individuals and businesses during the pandemic led them to increase their spending. It felt like free money, and to a degree, it was. Extra spending under many circumstances could be dealt with, but the pandemic years had another issue with a reduction in supply. 

The U.S. economy started to slow and go into a brief recession in February 2020. It got worse from there and didn’t start to recover until later in 2020. During this time, many businesses either closed or were open with limited support. Production dropped, and services declined due to reduced employee participation. 

The easiest way to see these supply chain problems is to look at the Supply Chain Pressure Index (GSCPI). In January 2020 the GSCPI was at a normal level of about 0 (the GSCPI shows the amount of deviation from the normal level of zero). By April 2020, the level had gone up to 3.27, a level higher than any time in the previous 12 years. The level didn’t come back to zero until February 2023. During that time supply levels were negatively affected by the accumulated problems from the pandemic. 

The result of the above is that we had high levels of demand driven by extended government stimulus payments and a depleted amount of supply due to the pandemic. So, high demand along with low supply gives you an almost perfect scenario for the monetary cause of today’s inflation.

What Does It All Mean For Today?

On March 31, 2024, the end of the first quarter, the S&P 500 index was up +10.56% year to date. We believe much of the market enthusiasm was based on good Gross Domestic Product (GDP), continued low unemployment, and the idea that the Fed was going to begin reducing interest rates soon. 

Now that we have seen the disappointing March CPI reading, we feel this narrative is starting to change. As evidence, the S&P 500, as of April 19, is up +4.1%. That is a drop of over 6% in just a few weeks. The simple truth is that the longer interest rates stay at these higher levels, the higher the cost of capital and the lower corporate earnings will be. And, as we’ve said before, the stock market is all about judging where corporate earnings are and where they are headed. Thus, we expect the market to be flat or slightly down until a clearer sign of inflation gets under control, and interest rate reductions are back to reality.

Can we get better CPI readings and have that happen by the July Fed meeting? Yes, but our feeling is that this process will drag out longer, and we may not see improvement and an interest rate decrease until the September or even November meeting. We expect a slow summer for the stock market.

All the best,

Barron Financial Group, LLP is a fee-only Registered Investment Advisor regulated by the Securities and Exchange Commission.

This newsletter is for general information only and should not be considered investment advice.  Investors should consult with a trained investment professional to discuss their particular situation.

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