What Did We Learn This Week? (12/06/2022)–Brainard
The Fed has Acknowledged that some Inflationary Pressures are Secular
Last week, the Federal Reserve Vice Chair Lael Brainard gave a speech that went largely unnoticed within the financial markets commentariat. While the speech didn’t give us any hints regarding the pace of Fed rate hikes, it told us something far more important about how the Fed views the US and the global economy long-term. For the first time, the Fed acknowledged what we have been talking about for several months: we have a secular, persistent and inexorable supply-side driven inflation problem. Brainard spoke to the “inelasticity of supply” which can be translated to say that we have a worker shortage and an energy shortage that aren’t going away beyond the near-term cyclical recession.
This speech was not the one-off musings of a Fed member gone rogue. Powell made several references to Brainard’s comments the following day when he addressed The Brookings Institute. My take is that this was a very intentional heads up to markets that the Fed understands we are in a new global economic regime of slower growth and tighter supply.
In the opening paragraph of the speech Brainard stated, “due to challenges such as demographics, deglobalization, and climate change, it could herald a shift to an environment characterized by more volatile inflation compared with the preceding few decades.” In other words, aging demographics, and the reversal of the last four decades of global integration means that we are facing a lack of labor supply in a manner that is unique to the modern global economy. The impact of climate change manifests itself most immediately and most acutely in the underinvestment in traditional energy, which means that as the world slowly transitions to renewable base power, the global oil industry will behave like any beyond mature industry: generate and return cash and avoid making investments in an asset-base that could become ultimately worthless. The risk here of course is that the transition will take a long time and the oil and gas is industry is constraining supply as if the transition is almost imminent. It isn’t.
Brainard goes on the say, “it is the relative inelasticity of supply in key sectors that most clearly distinguishes the pandemic- and war-affected period of the past three years from the preceding 30 years of the Great Moderation.” The importance here is the acknowledgement that the last thirty years of strong global growth but with declining inflation is over. That matters especially because while the dynamic of high growth and low inflation is behind us, equity multiples and the long-end of the treasury curve still reflect those largely halcyon years.
Brainard concluded her remarks, “some have conjectured that the slow and incomplete recovery of the workforce over the course of the pandemic may be the beginning of a longer-term change in labor supply dynamics. In addition, the potential for more frequent and severe climate events, as we are already seeing, and for frictions in the energy transition could also lead to greater volatility of supply. Together, a combination of forces—the deglobalization of supply chains, the higher frequency and severity of climate disruptions, and demographic shifts—could lead to a period of lower supply elasticity and greater inflation volatility…A protracted series of adverse supply shocks could persistently weigh on potential output or could risk pushing inflation expectations above target in ways that call for monetary policy to tighten for risk-management reasons. More speculatively, it is possible that longer-term changes—such as those associated with labor supply, deglobalization, and climate change—could reduce the elasticity of supply and increase inflation volatility into the future.”
Brainard has been viewed as one of the more dovish members of the committee, but that perception must now be called into question. The epiphany that the decades of transitory supply shocks have given way to durable supply constraints suggests that the treasury market pricing in rate cuts by late next year is far too optimistic. Why would a Fed that now has shown that it has embraced the reality that we are in a new inflationary regime start cutting rates unless we are in a deep recession? When Brainard says the Fed may need to tighten policy for “risk-management reasons” market participants need to understand that the good ole days of central banks ability and willingness to be a backstop for downside risks aren’t coming back anytime soon. The “Fed put” may not be dead but it is a hell of a lot lower than where it used to be.
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Tim Pierotti is WealthVest’s Chief Investment Strategist.
Tim has over 25 years of experience in various aspects of the equities business. Prior to joining WealthVest, Mr. Pierotti spent seven years in Equity Research management roles at Deutsche Bank and most recently at BMO where he was a Managing Director and Head of US Product Management. Tim has 11 years of investment experience most notably as Head of Consumer Research and Portfolio Manager at The Galleon Group, a former NY based $8Bln Long/Short hedge fund. Tim is a graduate of Boston College and lives in Summit NJ.
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