In the early morning notes sent out to subscribers, we talked about the Federal Reserve's monetary policy and how we will position our portfolio for 2022. In this post, we're delving further to discuss one determining factor for Federal Reserve's monetary policy, which is inflation.

One of the driving factors for Federal Reserve's monetary policy is inflation. Currently, they have a dual mandate, which are price stability and sustainable employment. On the inflation front, they judge that inflation at the rate of 2% measured by Price Index for Personal Consumption Expenditures (PCE) is consistent with their mandate.

Last week we got a 6.2% CPI reading which was discussed across the stock market and even the media outlet (news, social media). For starters, let’s keep in mind that CPI is not the appropriate proxy as it includes highly volatile food and energy prices. Take those out and the core CPI was 4.6%. That's still a hot print, but not quite as hot as what the inflation hawks are throwing around. Furthermore, keep in mind that the Fed’s preferred measure of inflation is the core PCE index, which registered a 3.6% rate in September for the fourth month in a row.  We’ll see what October has in store when the results are released next month. We want to see PCE remains at this level, or better yet, decline. 

We think it’s also important to remember that the Fed has been trying to generate some inflation for nearly a decade. Prior to 2021, they have struggled and failed to hit their 2.0% yoy target. Looking over 10 years, given the Fed's desired 2% yoy increase in PCE, prices today compared to 2012 should be up 22%. The actual number is 18.3% (PCE 2012 compared to 2021). So we're still under-hitting the inflation target set by the Federal Reserve. Bottom line, while the recent price increases have been rapid in recent months, prices still have not reached the levels the Federal Reserve has been targeting over the past decade. 

Of course, the stock market bears fear that inflation is going to get away from us and run at an accelerated pace for a long time. We believe it is important to identify some forces that could change the inflation trajectory for the better (deflationary):

• The supply chain bottlenecks is seen as temporary, and will be eased when the entire world reopens from Covid thanks to vaccination efforts.

Example: Most of Nike's factories are in Vietnam, which has been under strict Covid shutdowns since Spring. This reduces inventory, and given strong demands in the US, has led to higher shoe prices. But Vietnam is ramping up vaccination, reopening, and will solve this supply chain issue soon.  

• Labor supply could come back into the market as stimulus money sitting in savings accounts is spent.

• The rise in oil prices — which contribute to the CPI reading — has stalled. Rig counts are going up (see our last week's roundup)

• And perhaps most importantly, once we are past these temporary dynamics, the longer-term secular deflationary force that is technology (think specifically digitization and automation), will remain in place and likely act as an even greater force than before the pandemic due to the acceleration we saw in 2020 and 2021.

In conclusion, when the market bears come out and tell you about rampant inflation, we think it worthwhile to zoom out and take a longer-term view. In the short term, as a trader, these headlines and commentaries can hurt stocks, but in the long term (which is what we do here), these declines are opportunities to seek out high quality long-term secular investments.