Why Commodity Prices Will Not Deter the Fed

Surging commodity prices are complicating an already difficult inflation picture for central banks. The inflationary impulse is clearly to the upside and not just from oil prices, but from most commodities used in the stuff we consume and the stuff we eat. It means prices are heading to levels not seen since the 1970’s. However, surging commodity prices also have a deflationary impulse. It erodes purchasing power, reduces aggregate demand, creates excess slack in the economy, and ultimately exerts downward pressure on inflation. That effect can be magnified further as interest rates rise. The question is, in this tug of war which will prevail and how will the Fed position itself?

The best way to consider this is to see how resilient the economy is to higher costs. The chart depicting the percent of disposable income households pay for core expenses such as debt servicing, energy, and food shows room for optimism. It shows the level of this spending has jumped and will do so again in the current quarter, but it remains around historic lows. In effect, the rise in food and energy feels nasty, nobody likes it, but from a macro level perspective looks manageable. The economy is simply better able to absorb the shock of higher prices without suffering a major setback to growth. In addition, since 1980 household wealth has surged and the overall energy intensity per unit of GDP growth has steadily declined. That too helps.

The deflationary impact from higher commodity prices will therefore be modest, and manageable at levels we have seen thus far. GDP forecasts for 2022 have been trimmed, but the overall thrust of solid growth remains intact even if it is off the pace of last year. Record highs in job openings and strength in the labor market are consistent with this outcome.

The bad news is that the inflationary impulse will prevail, and we do not see the Fed accommodating higher commodity prices with loose policy as was the case in the 1970’s. Neither do we envision a Volker II moment when the Fed faced similar supply side driven inflation and caused two recessions to bring it under control. We do look for the Fed to remain on track for a trajectory laid out over previous months.

If anything, it is easy to envision even more tightening. The Fed knows that inflation can erodes real purchasing power. Moreover, the Fed’s inflation credibility is at also stake. Breakeven inflation expectations have surged and the 5y5y forward inflation measure, a measure of inflation persistence, is nearing eight-year highs.

Rising interest rates, reduced central bank liquidity, and an upward drift in credit spreads are part of the normalization process. This makes for a difficult environment for both fixed income and equities. Investors are well advised to diversify their portfolios accordingly.

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