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“Transitory” Inflation and The Federal Reserve Bank

The Federal Reserve has had two main objectives since its creation. One includes maintaining full employment in the economy and stable price levels. Another not-so-common job the Fed is tasked with is acting as the lender of last resort. In a nutshell, the Fed stands ready and willing to prevent financial catastrophe, whether it be the sub-prime mortgage meltdown or short-term liquidity imbalances in asset caused by shutting down the economy due to the pandemic.

However, with all the bond buying over the years, the Fed’s balance sheet has swelled to $8 trillion. One has to wonder what the effects will be on the price levels paid for goods and services. If you watch CNBC, or have read the money section of the Journal, you have probably come across discussion or articles written about inflation. Inflation is the increase in the general price level of goods and services in the economy. There are a few methods used to track the changes in price levels.

First, the Consumer Price Index (or CPI) is a commonly reported measure of price level, and it measures the average change over time in the prices paid by urban consumers for a basket of consumer goods and services. An additional method for measuring the change in price level is the Personal Consumption Expenditure Price Index (PCE). The PCE is a measure of the prices that consumers pay for goods and services. It differs from the CPI because the goods and services are weighted differently. The PCE is also able to capture changes in consumer spending habits.

So now that we have some basic definitions out of the way, one would naturally ask, “which one does the Fed utilize in setting monetary policy?” Currently, the Fed uses the PCE as its primary tool to assist with policy decisions as it pertains to the stable price level mandate. And by stable, we mean that the Fed currently targets an annualized 2% price level increase (the Fed wants current price levels to track close to this +2% trendline).

What does the Fed do when price levels are above the trendline? It has the ability to adjust the Fed Funds target interest rate, or it may even use language in the Fed meeting minutes that may adjust consumers inflation expectations. Recently, you have heard the term “transitory” inflation mentioned by Federal Reserve chairman Jay Powell.

What does it mean for inflation to be transitory? Transitory inflation is defined as a temporary increase in prices for goods and services. The problem that arises is that there is no one definition for what temporary means in terms of time frames. One example could be supply chain disruptions that cause short-term price increases for products and manufacturing inputs. It is difficult to clearly define what transitory inflation actually means. The Fed may be using this terminology as a means to adjust consumers inflation expectation downward.

What this means is that we do not have a crystal ball as to whether price levels will remain elevated above the Fed’s 2% steady state growth rate. What we can do is use the data that we have in front of us and follow our investment process. What we have in front of us is the reported monthly CPI data at +5.3% over the most recent 12-month period. Also, we have PCE tracking at 4% at present. So, we are above the trendline at the moment. However, these numbers can go either way.

What can we do as asset managers and financial planners? We use the data that we have at our fingertips and follow our process that says to include other non-correlated asset classes such as broad-based commodities, gold, silver, and other assets including digital assets like Bitcoin and Ethereum. As financial planners, we take a conservative approach and even include future cost of living expense increases. We work hard to take a reasonable and logical approach toward the inflation discussion with all our financial planning clients.

Categories: News, The Market

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