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Posted by Ragheb Othmani on Sep 14th, 2023

Inflation’s Silent Alarms: A Deep Dive into Central Banks’ Blind Spots

After returning from a lengthy trek through a national park, I walked through my front door, eagerly anticipating some much-needed rest. But as I settled in, my phone shattered the silence with an unexpected question from a friend – not a financial analyst but a mechanical engineer. “When’s core inflation going to drop?” It was past midnight, and I was caught off guard. As he vented about his spiralling mortgage payments, I knew this wasn’t just a concern for economists… it was impacting everyone.

So, with the benefit of hindsight, I wanted to spotlight specific early indicators, particularly within the US, that foreshadowed the mounting inflation. Perhaps an earlier recognition of these signals might’ve fostered better economic outcomes. It’s possible that central banks did, in fact, integrate these into their strategies. Still, their surprise at the inflationary surge suggests the opposite – or at the very least, they were underemphasized.

I also wanted to look at the current status of these metrics and offer a perspective on the trajectory that we might encounter. There’s a noticeable trend of cooling, which suggests a potential ease in inflationary pressures moving forward. For further details and analysis on Purpose Investment’s outlook for the upcoming economic cycle, read our whitepaper, Preparing for the Next Bull.

Rethinking central bank strategies

The call for innovation

I’m not in the business of playing the blame game about inflation and interest rates. Still, there’s no denying that some red flags, if heeded, might have spared us a fair share of the current economic woes.

In the eye of recent economic and inflation issues, it seems that central banks missed the boat on some crucial data. Their focus on “transitory” drivers of inflation, combined with massive cash infusions via quantitative easing (QE) and keeping interest rates at historically low levels for extended periods, painted a part of the picture we’re seeing today. And while the enormous government expenditures during the pandemic and Covid ripple effects on employment and productivity played the leading role, there’s more to the story.

In this shifting economic context, it was essential for central banks to embrace innovative strategies, especially by emphasizing metrics that signalled early inflationary trends before they reached the consumer. Scrutinizing sectors like housing prices, equity markets, bank deposits, and emerging metrics (like digital assets) can offer key insights. These areas often absorb significant liquidity boosts and can be precursors to broader economic changes, sometimes before consumers feel inflation.

the Fed waited until March 2022 to switch

The Federal Reserve maintained rates at unprecedentedly low levels for a prolonged duration, even in the face of early warning signs of inflation.

A passage from the Minutes of the Federal Open Market Committee in June of 2021 offers a glimpse into their perspective on the transitory nature of inflation:

“Over the next year, the transitory price increases caused by bottlenecks and supply constraints were expected to largely reverse, and the growth in demand was forecast to ease. As a result, inflation was projected to slow to slightly below 2 percent in 2022.”

However, the situation was more layered. The core Personal Consumption Expenditures (PCE) Price Index, a vital inflation gauge for the Fed, was already rising. More critically, other early indicators raised red flags, suggesting that inflation might not be as transitory as anticipated and that its roots might delve deeper than supply chain bottlenecks.

Initial signs of inflation overlooked by the FED, PCE Price Index, and CPI

The home price rollercoaster

While including home prices in inflation indices has been a subject of prolonged discussion, the period between late 2020 and early 2022 brought it to the forefront. During this time, the S&P/Case-Shiller US National Home Price Index registered its steepest annual percentage rise since its establishment. Yet, despite these clear signals, the most significant US inflation indicators, like the CPI and PCE Price Index, sidestepped this trajectory. Instead, they were anchored to rent measures, reflecting housing costs via rents and owners’ equivalent rent, but not the actual sale prices of homes. This leads to an alarming and pressing question: given the unprecedented rise in home prices, shouldn’t the Fed have sensed an urgent need to reconsider its stance on rate and asset purchase policies as early as late 2020 and throughout 2021?

Such steep increases in home prices were not merely indicative of individuals having surplus cash; they were also the result of the allure of historic lows in mortgage rates. An article published in 2021 on the Federal Reserve Bank of Dallas website provides valuable insights into the factors driving the housing market demand at that time:

“During the pandemic, large transfer payments that included stimulus checks and extended/expanded unemployment benefits boosted household incomes. As a result, household incomes and housing demand did not collapse when unemployment spiked to a seasonally adjusted 14.8 percent in April 2020 (from 4.4 percent a month earlier).

In addition, very low mortgage interest rates, reflecting market forces and very accommodative monetary policy, raised the demand for housing. The Federal Reserve cut its policy rate to the effective lower bound (0 percent), purchased large quantities of Treasuries and mortgage-backed securities (quantitative easing or QE), and provided forward guidance that the fed funds rate was likely to remain at the effective lower bound for an extended period.”

Significant rise in home prices during 2020-2021

The equity market playground

Picture this: Amid the pandemic’s chaos and stuttering economies, retail investors are making waves in the stock market. Their share of trading in the US surged, and there was a notable spike in web traffic for retail brokerages. They’re pushing up the valuations of companies like GameStop, AMC, and a long list of what was called then “meme stocks,” even though stock prices arguably didn’t reflect the firms’ actual worth at the time. This frenzy indicates one clear trend – people were flushed with extra cash, hinting there might not have been a need to inject more funds into the system, potentially exacerbating inflation.

Meme stock frenzy in early 2021
Web traffic for retail brokerages reached new highs in February
Source: CNBC

Bank deposits surge and the excess supply of money

In 2020, due to governments’ generous stimulus packages, specifically in North America, there was an unprecedented surge in the money supply, paralleled by a noticeable spike in bank deposits. This became apparent nearly two years before the Federal Reserve and Bank of Canada reacted with a rate hike, underscoring a fundamental principle rooted in the Quantity Theory of Money: when there’s a significant increase in the money supply that isn’t matched by a corresponding rise in production, inflation becomes a predictable outcome. Another crucial factor is the velocity of money, which had diminished during the Covid pandemic. However, as economies reopened, regulators should have anticipated the resurgence of the cash rate, which would likely provide sustained inflationary pressure, not just for a transitory period.

Recently, growth in deposits and money supply has witnessed a sharp decline. However, the data may be skewed due to inflows into money market funds, which aren’t fully reflected in the figures. Nonetheless, it’s reasonable to infer that both metrics currently indicate a cooling trend.

The unprecedented increase in deposits in 2020

In the early stages, the Fed underestimated the potential influence of the significant increase in money supply on inflation. This perspective was evident when Fed Chairman Jerome Powell addressed the Semi-Annual Monetary Policy Report to Congress in February 2021:

“We have all been living in a world for a quarter of a century and more where all of the pressures were disinflationary, you know, pushing downward on inflation. We have averaged less than 2 percent inflation for more than the last 25 years. Inflation dynamics do change over time, but they do not change on a dime, and so we do not really see how a burst of fiscal support or spending that does not last for many years would actually change those inflation dynamics.”

Digital assets and the inflation signal

The conversation around digital assets has persisted for years. However, amidst a global pandemic, the significant surge in their market capitalization during 2020-2021 offers a telling insight into inflationary pressures.

Advocates of digital assets might interpret this surge as a sign that a substantial portion of the market foresaw a depreciation in the value of fiat currencies, especially with governments releasing vast sums of money relative to actual production. On the other hand, skeptics could attribute this rise to investors being flush with extra cash. Either way, the overarching implication was clear: a potential depreciation in fiat currencies and anticipated inflation.

The surge in digital assets market cap from 2020-2022

Metrics are now pointing to diminishing inflationary pressures

Based on the metrics previously discussed, there’s a clear trend of cooling, suggesting a potential ease in inflationary pressures moving forward. This positive shift offers a glimpse of hope for greater economic stability in the near- and mid-term. However, it also raises a critical concern: Have central banks now overcompensated by increasing rates too aggressively after potentially delaying their initial rate hikes?

Final thoughts

The recent past has been rich with economic insights. If regulators, governments, central banks, and other vital institutions had been more innovative and vigilant, we might have avoided some of our current challenges. As we chart a course for the future, it’s vital for these entities to dig deeper, not just reading between the lines but also arming themselves with innovative tools to better understand and navigate the complexities of inflation.

– Ragheb Othmani is an Investment Analyst at Purpose Investments


Sources: Charts are sourced to Bloomberg L.P. unless otherwise noted.

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Ragheb Othmani, CFA

Ragheb has extensive experience in asset management, investment analysis, clients’ communication and products development and works within the portfolio management team to identify opportunities in debt and equities.

Besides covering banks and financials in Canada and the US, he works with the team on other sectors such as REITs and mortgages REITs, retail, hospitality and others.