July 23, 2021

The economy is on a roll with no appreciable slowdown in sight.  The stock market reaches a new record high level every few weeks.  Bond yields are lower than anybody expected with inflation on the rise.  With such a heady economic and investment climate both economists and market participants are looking for potential problems.   Last week the stock market got a case of the jitters and fell several percentage points.  The excuses seemed to center around a pickup in the number of COVID cases and another surge in virus, and faster than expected inflation which could trigger a rate hike sooner than 2023.  Both of those concerns seem unwarranted.

With respect to the Delta variant of the COVID virus, it is true that cases have been on the rise. After reaching a low of about 13,500 new cases daily in June, cases have climbed to about 37,000 currently.  Are cases likely to continue climbing rapidly?  We doubt it.

The CDC reports that 187 million people have received at least one dose of the vaccine and that 34 million people have already contracted the virus and, presumably, are also immune.  That is a total of 221 million Americans out of the population of 330 million that already have immunity.  Thus, there are 109 million unvaccinated people remaining.  Given that the Delta variant seems to affect only unvaccinated people, there is a relatively small number who can potentially catch the virus.  So while the number of cases could climb further, is unlikely to climb appreciably.

And while the number of new cases are on the rise, deaths are not.  The infectious disease experts tell us that while the Delta variant remains highly contagious, it also does not seem to produce serious illness or death.  If so, the Delta variant is not going to seriously reduce the pace of economic activity.

Meanwhile, the inflation rate has picked up far more quickly than the Fed expected.  In the past year the so-called “core” CPI has climbed 4.5%.  The Fed believes that the temporary factors boosting inflation should begin to dissipate immediately so that the core CPI will rise 3.0% in 2021 and 2.1% in 2022.  The problem is that the inflation rate still seems to be accelerating, not slowing down.  We expect the core CPI to rise 5.3% this year and 3.7% next year.  That is not even close to what the Fed had in mind.

As a result of the pickup in inflation the market frets about a rate hike sooner than 2023.  That fear is also unwarranted.

If the Fed wants to reverse its easy money policy, the first step is for it to cut back on its purchases of U.S. Treasury and mortgage-backed securities.  It purchased about $3.0 trillion of such securities during the recession, and it continues to purchase $120 billion per month.

These purchases of securities are boosting growth in the money supply.   Money growth surged during the recession to a record-shattering 27%.  Its steady purchases of securities are allowing the money supply to continue growing at about a 15% pace, far faster than its long-term average growth rate of about 6.0%.  No wonder the inflation rate has been climbing!

Thus, the Fed should immediately stop purchasing U.S. Treasury and mortgage-backed securities.  But the Fed has indicated that it will not begin to do so until much more progress has been reached towards achieving full employment.  The unemployment rate is currently at 5.9%.  The Fed believes full employment is about 4.0%.  Even in our optimistic view of the economy, the unemployment rate will not approach the 4.0% mark until the end of this year.  For that reason, the Fed is not going to be in any hurry to take even consider taking its foot off the accelerator.  It has begun to discuss the tapering process but that process will take several more months.  Thus, tapering is unlikely to begin until early next year.  And once it starts the tapering will be slow and gradual.  It is unlikely that the tapering process will be completed sooner than the end of 2022.

Only then will the Fed consider raising the federal funds rate.  That is unlikely to occur until sometime in 2023 which is the time that most Fed officials have suggested.

So, as we see it neither of the two fears the market seems most worried about – spreading of the virus, and a sooner-than-expected increase in interest rates by the Fed – are warranted.  For now, the economy should continue to expand at a vigorous pace for the foreseeable future, and the Fed will remain on the sidelines through yearend.

Stephen Slifer


Charleston, S.C.