Ladies and Gentlemen, Please Fasten Your Seatbelts and Prepare for Landing

Federal Reserve Chairman Jerome Powell delivers the Federal Reserve's Semiannual Monetary Policy Report to the Senate Banking Committee in Washington, on Feb. 26, 2019. Joshua Roberts/Getty Images

Commentary

It’s a phrase I haven’t heard in a long time.

You would hear it back in the days before zero interest rates ruled the land when the Fed actually used interest rates to manage its monetary policy.

It referred to one outcome of a Fed policy adjustment when an economy got overheated.

It’s called a “hard landing.”

When the economy becomes overheated, usually due to too easy monetary policy, the Fed would step in and start raising interest rates to cool things down. If they were able to gradually adjust rates without inflicting undue economic pain on people and businesses carrying debt—i.e. if it didn’t send the economy spiraling into a recession—it was called a “soft landing.”

If crosswinds picked up on the final descent. … Well, I’m sure you get the point.

Throughout most of 2021 Goldman Sachs, in lock step with the Fed, painted a pretty rosy picture about inflation being transitory. Just recently, they’ve changed their tune.

And it’s not a pretty picture.

A Long-Forgotten Cause of Inflation

Since the partial re-opening of the global economy, the threat of inflation has largely been blamed on two main factors. The first was the crippled supply chain. And that is most definitely a factor. Products haven’t been available and the supply disruption has been wreaking havoc in everything from food to semiconductors to the great necessity... toilet paper.

The second cause has been attributed to some $13.8 trillion that has been pumped into the economy between actions on the part of Congress and the Fed. Too much money chasing too few goods—the classic recipe for soaring prices.

But there’s another, even more significant factor operating under the radar that’s likely going to make things worse than most expect. It operates differently than the money/goods scenario. And to understand it, you have to go back to your college econ textbook to understand it.

It is called wage-price inflation.

The theory of wage-price inflation basically says, “Rising prices increase demand for higher wages, which leads to higher production costs and further upward pressure on prices creating a conceptual spiral.” (emphasis mine)

And while all the chatter of late has been about the employment situation, a rather big factor that’s been overlooked has been the recent spike in wages.

This past January, average hourly earnings were up 0.7 percent which boosted earnings by 5.7 percent on a year-over-year basis.

Average Hourly Earnings Year Over Year. Tradingeconomics.com

When the Fed’s Usual Tools Don’t Work

It’s really only anyone’s guess—including Goldman—as to how much a wage-price spiral will drive the current inflation situation.

But you should know this type of inflation is more difficult to control. When strict monetary pressure is the cause of inflation, the Fed can work its magic to drain liquidity from the system and slow things down.

Wage-price inflation is different.

Wage-price inflation is typically sparked by inflation expectations becoming unanchored from the Fed’s target—i.e. when the average worker no longer believes the Fed can control inflation within its 2 percent target range. This leads to demand for higher wages. … Which leads to higher costs. … Which leads to higher prices. … Which leads to demands for higher wages… and so on.

And it was what Goldman noted in their report: “Even if wage growth comes down from 6% to 5%, as we expect, this would imply unit labor cost inflation of at least 3% assuming productivity rises no more than 2%. If it persists, such a pace would be too high for achieving the Fed’s 2% PCE inflation target. This raises the risk that Fed officials would want to see an even bigger slowdown in output and employment growth than we are currently forecasting, to a pace no faster than the long-term trend.”

In other words… buckle up.

When inflation expectations become unanchored, the Fed usually has to squeeze a little harder to get the economy under control.

Despite the fact that the Fed has never actually engineered a “soft landing,” you can still hope for the best. But it’s probably best to be prepared for the worst.

During recessions there are a couple sectors that tend to outperform the market. One is the “consumer staples” sector—the Consumer Staples Select Sector SPDR ETF is a play worth considering there. The other is plain old precious metals—like the SPDR Gold Trust (GLD).