Between a rock and a tighter place

As expected, increased consumer spending has driven the recent economic recovery. But will it continue? A supply-demand mismatch in the labor market, increased input costs and a shift in consumer sentiment have made the Fed’s job difficult while COVID-19 lingers. SVB Private Chief Investment Officer Shannon Saccocia weighs in on the Fed’s inflation dilemma. Listen now.


Hello and welcome to SVB Private Perspectives. I'm Shannon Saccocia, chief investment officer at SVB Private, and I want to thank you again for joining us today.

On today's podcast, I'm going to touch on one of the biggest challenges facing investors, economists and policy makers in the coming months, and that is inflation. While we have been discussing the potential for inflation to upset the Fed and other central banks' accommodative approach, recent economic data releases have indicated that the risks appear to be rising.

As we've discussed previously, consumer activity is by far the most important driver of the global economy and was certainly expected to be the main driver of the anticipated robust economic recovery coming out of the pandemic. That has proven to be the case. We have seen a significant increase in consumer activity over the course of the last 9 months. Some of this has been fueled by stimulus payments here in the United States as well as other programs to encourage services spending in the UK. And consumers have come out in force, particularly over the last 2 or 3 months to start spending on services, things they hadn't been spending on for the last year or so.

An increase in consumer spending triggers unintended consequences

Although we did see continued goods spending over the course of last summer, as well as into the fall, really, this return of services spent, which had become a much bigger percentage of consumer spending over the last several years, given the shift from sort of buying things to buying experiences, we've really seen that accelerate over the course of the last few months. And one of the things that many folks looking at their portfolios, particularly in the equity side of their portfolio last year, was looking to potentially take advantage of this return of the consumer back to areas like travel and hospitality, areas that had been decimated during the pandemic.

However, what's happened is that, with this very sharp and significant shift in demand in this very short period of time, there have been a number of unintended consequences. So, the first place we're seeing that is in the employment market. So, in the labor market currently, we are in a situation where we have a lot of job openings and we still have a lot of people who are unemployed.

So, unemployment rate has not recovered to its pre-pandemic level, we still have a number of people that are receiving unemployment benefits. In some states, they're still receiving expanded or additional unemployment benefits, as provided by the federal government through its various COVID-19 relief packages. And there is a clear and present need for employers, particularly in the sharply recovering services industry, to hire people.

And with this mismatch, there has been incremental increases in wages in order to create a more attractive proposition for some of these companies. It remains to be seen, over the course of the next couple of years, if this supply-demand mismatch in the labor market can be overcome. Or if, instead, there are people who took the opportunity, during the pandemic, to make the decision that certain services roles, which are the vast percentage of the job openings that are available currently, are no longer for them.

And, so, one of the things that we're looking at is, "Are these businesses going to be able to fill the roles that they have open?" "Will wages need to continue to rise?" And why that's important is that companies don't digest all of those costs internally. We've also seen higher input costs. So, notwithstanding the significant supply-chain disruption that we experienced last year and the fact that for many companies with vast global operations many of their supply chains were disrupted from this pandemic from the inability to travel, from the inability to keep workers employed due to the pandemic.

And, so, input costs started to rise. You couple that with this massive increase in demand, and clearly, whether it's commodities or whether it's finished goods that go into rebuilding a house, such as windows, all of those input costs have started to rise.

And, so, all of these companies are now facing, particularly small businesses are facing the potential to have to pay more higher wages against a very small pool of applicants for many positions, higher input costs. And what's happened is that we've experienced this flow through of higher prices to the consumer.

Now, it hasn't been one for one. For instance, last month, in the month of July, producer prices rose almost 8% and consumer prices rose 5.5%. And that typically occurs, producer prices rise, the next several months they try to pass those costs on to the consumer. They also are likely to try to mitigate those higher costs but can't do it overnight. So, whether that's through changing inputs if you've been ordering anything that you've ordered historically, that comes in packaging, you'll notice that, in many cases, packaging looks different than it did previously. And that's a result of not only some of these disruptions but also companies looking to avoid margin compression by finding substitutes that are available at a lower price.

Shifting consumer sentiment coincides with advancing inflation

And so this inflation, as expected, has been flowing down to the consumer. And, at first, it appeared that, particularly here in the United States consumers were willing to pay those higher prices given the fact that for many, particularly those who were able to continue working through the pandemic, for the ability to move from an office location to a home location and continue to be employed, not having that outlet for spend results in a much higher savings rate.

So, some of that savings is starting to be spent down. Couple that with, as I mentioned, expanded unemployment benefits and stimulus checks, it did seem that consumers felt that it was perhaps they were paying slightly higher prices. But, against the backdrop of a year in which many people didn't get to live the life that they had been accustomed to prior to the pandemic, it seemed to be an acknowledgement that perhaps this was the result of that and that higher prices were here to stay.

Interestingly, more recently we've started to hear from consumers, through consumer confidence surveys, that perhaps they are becoming more concerned about these higher prices. And you can point to, again the fact that we're not receiving any more stimulus checks, the fact that many of these expanded unemployment benefits are no longer available. And will likely not be available anywhere over the next several months.

And you look at that in terms of, "What does that look like for the consumer basket over the next 12, 18, 24 months?" And what consumers are saying is they're saying, "I feel like currently I'm paying too much for some of these major purchases." One of the areas of inflation that we've seen that's been most pronounced is in something like used cars.

And it seemed as if those prices were continuing to rise and it seemed as if the demand was continuing to be fairly inelastic or unchanging based on those higher prices, that type of purchase is exactly the type of thing that consumers are now starting to balk at .

And, so, from that perspective, if they look out over the course of the next year maybe this robust improvement in consumer spending could wane a bit. There's also a very straightforward rationale for why consumer confidence could be waning as well and that is the rise of the delta variant.

Covid-19’s economic impact remains top of mind

So, much was made about the necessity to get at least 70% of the population vaccinated in an effort to ensure herd immunity. With many people already stricken by the COVID-19 virus earlier on in the pandemic, you had both that anticipated immunity for those people but also with this big push for vaccination. And it was expected that, as we saw cases subside into the beginning of the summer, that perhaps we had moved past the worst of the pandemic and could look forward to something akin to what we experience every year with influenza.

Where there might be additional strains typically a vaccine that's available, some years it's more effective than others. But it is also anticipated that there would be perhaps the need for additional boosters that could mitigate a significant increase in cases as we move into the fall.

Of course, the delta variant has proven to be more contagious. The effects are apparently more severe than previous variants of COVID-19. And we are seeing, unfortunately, albeit still a small percentage, breakthrough cases for vaccinated individuals. And that coming into the fall and winter, which has been more challenging, particularly for some of the larger population centers in the United States, such as the Northeast, over the last year, that's creating some concern in consumers as well.

The fed’s ongoing dilemma

And, so, what can be done? Because, if you think about the intent of the Fed, for instance, they are looking at their dual mandate of inflation and employment and they are seeing improvement in the employment situation, improvement in the labor market. There still seems to be a mismatch. But the potential for improving employment, there still seems to be momentum behind the fact that with anywhere from 700,000, 800,000, 900,000 jobs being added from a non-farm payroll perspective each month, clearly, we're on a trajectory for an improvement in the labor market here in the United States. And it's unlikely that the Fed will wait to get back to pre-pandemic numbers before they have a case to start tightening.

On the flip side, the Fed is very concerned about this trend of higher prices in the consumer basket. The fact that they're hearing from consumers that they are concerned to make large purchases, that they are concerned about the relative purchasing power that they're experiencing based on these sharp increases, particularly in things like food and gas, that creates concern from the Fed because, at the end of the day, that pass through from producers to consumers and then consumers' ability to continue to maintain their purchasing power of their consumer basket is really at the heart of it, what the Fed is most concerned about when they talk about their inflation mandate.

The flip side is that, if they choose to start tightening, likely first through the tapering of bond purchases, so decreasing that amount on a monthly basis and whether they start that in January, they start that in March, that's on the horizon, but, potentially, accelerating that taper could mitigate some of the inflationary impacts. It could also slow an economy that, as of right now, we're not sure what the potential economic impact of the delta variant or a subsequent variant that could take hold the same way delta has, over the last month and to 6 weeks, that's an unknown for the Fed.

They assume that there will not be the level of economic destruction that we experienced last year because there will not be the level of lockdowns and social restrictions that were put on the U.S. economy last year. However, what's much more difficult to gauge is the behavioral response that could come from consumers that are, one, feeling the pressure of higher prices and, two, feeling the pressure of this is a here-we-go-again situation with COVID-19, "I was increasing my spend on services, I was increasing my spend outside of the home. Perhaps now it's time to ratchet that back."

We're hearing from airlines that, what they call, near-term bookings, which is cancellations that are very close to flight date are increasing, as cases increase. And we still have a population here of children under the age of 12 who are unvaccinated. There is no option for them. And while they still make up a very small percentage of cases certainly families with children in thinking about taking that trip or, potentially, doing something outside of the norm, there is going to be a behavioral response to what we're seeing.

And, so, the Fed is stuck currently between knowing that, at the end of the day, their mandate has focused on inflation but also that pulling out the rug from underneath this economic recovery, akin to what happened back in Europe, that resulted in the European sovereign debt crisis when the European Central Bank raised rates too quickly after the 2008-2009 financial crisis, the Fed is loathed to make that mistake again and create a similar experience here in the United States.

And, so, it will become as if the Fed was not already under an immense amount of scrutiny and as if Chairman Jerome Powell didn't have enough to worry about. Now they're trying to balance how hot can they allow inflation to run, how long can they hold themselves to this idea that this is transitory, and can they hold the line on that for the next 6 to 9 months knowing that, at the end of that period, consumers could be facing higher prices and wages that aren't higher enough to offset some of the effect on that basket. And that for the Fed would be a very undesirable outcome.

Thanks again for listening to this week's podcast. I want to encourage all of you to reach out to our team here, at Boston Private, with any questions or concerns you may have. If you have any questions or thoughts on my points today, you can find me on Twitter @ShannonSaccocia. You can also read our latest perspectives on the markets, the economy, financial planning and where we go from here by visiting Boston And if you want all of this information delivered right to your inbox, I encourage you to sign up for our newsletters while you're there. Be sure to subscribe to the Boston Private Perspectives on Apple Podcasts, Spotify or wherever you prefer to listen. And I look forward to coming to you again next time.

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