Here’s why the Fed will raise rates this year

If the COVID-19 pandemic was the defining “black swan” event of our generation, then rising inflation is the “white swan” event that will dominate our lives for the foreseeable future. “White swan” events are events that are easily predictable and easily avoidable, but for some reason no one seems to do anything about it, and in this case it is rising prices. The FOMC is trying to assure us that hyperinflation is transitory, but we disagree. The facts do not indicate that the recent spikes in consumer prices are transitory and will result in the FOMC raising interest rates this year. The real question for investors is whether to prepare for such an event, and we think the answer is yes. If you think about it, the FOMC has been begging the economy to start raising rates for years, and it is finally starting to listen.

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Inflation is already here, and there’s no getting away from it

The really scary thing about the inflation picture is that inflation is already here, and no one is doing anything about it. Starting with the Fed’s preferred measure of core consumer inflation, the PCE price deflator, inflation surpassed the FOMC target of 2% in March and has only accelerated since then. PCE accelerated at the core level from 1.9% in March to 3.1% in April, and we expect it to be higher in May and June. No company on the S&P 500 list is talking about price declines, if anything it is talking about the impact of rising manufacturing costs, rising wage costs, rising commodity prices and the need to raise prices to offset these pressures.

The consumer price index says the same thing. The Consumer Price Index has been above expectations for the past 2 months and accelerated from April through May, up 5.0% for the year. This is more than double the Fed’s 2% target, and that growth is accelerating. If we were talking about GDP or earnings growth, the hot numbers would not be such a big deal. Last year, GDP was down 30% and most companies’ revenues were down double digits, making this year’s numbers incredibly good. Nevertheless, the economy and corporate profits have only barely returned to pre-pandemic growth levels. Inflation did not decline last year. It slowed to about 0.5% and then accelerated again and continues to accelerate. If ever there was a time for the Fed to act to rein in inflation, we believe that time is now.

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Core inflation data does not measure actual inflation

If inflation is the net result of price increases for consumers, then core consumer inflation data does not measure what it should. The two items most affecting consumer spending are energy and food, and those are the first two things taken out of the equation. When they are included, the impact of the index often doesn’t match reality. We know from the signs on the streets and the prices we pay that gas prices are almost double what they were last year. That’s a 100 percent increase in energy inflation, which is not measured correctly, and that cost is reflected in food prices.

The biggest cost to food producers is energy, and if it is more expensive for them to buy gas, it will be more expensive for us to buy food, and this applies to many other sectors of the economy. According to the CPI, housing costs only went up 2.2% last year, but we know that lumber, building materials and home prices are up at least 20% from last year, and that’s a very generous estimate. According to the Case-Shiller report, home prices are up at least 20% and lumber prices are up three times as much. In our opinion, real consumer inflation is already developing at a double-digit rate.

The Fed knows more than it lets on

You have to be very naive to believe that the FOMC doesn’t know more than it says it does. We believe this is evidenced by the dramatic shift in the Fed’s stance that we have seen in the committee over the past six months. At the beginning of the year, even in March, the FOMC was predicting at least two years of a zero interest rate policy, no need for interest rate cuts or hikes. Now, six months later, a group of them are babbling about “tapering talk,” along with their buddy, Treasury Secretary Janet Yellen (cough, cough FOMC head), who thinks a rate hike may be necessary. For us, the question of the June FOMC meeting is not whether they will change their words in a statement, but what exactly they will change and how it will affect the market. In our view, the market should be prepared to be put on a firm path to cut and raise rates.

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