Economic calculus

Quick takes:

• Inflation remains elevated
• Inelasticity of energy
• Worse inflation ahead?
• Fed set to start tightening
• CRE remains in a favorable position

Calculus is defined as the mathematical study of continuous change. As the Fed meets this week to analyze the economy and chart the path forward for monetary policy, they will face a complicated and precarious form of economic calculus. The world and the global economy continuously change. Yet events of recent weeks further remind us, even after the last two years, that continuous change does not mean constant or predictable change.  

The rate of inflation

The consumer price index (CPI) for February showed headline inflation rose 7.9% year-over-year while core inflation rose 6.4% year-over-year. Both were the highest respective rates in roughly 40 years. While inflation continued to increase broadly, core goods inflation remains the driving force pushing inflation to multi-decade highs. Core goods inflation had seemingly disappeared for years before returning with a vengeance during the pandemic as consumers purchased goods from the relative safety of their homes. Reflecting high inflation, consumer sentiment in early March fell to its lowest level since September 2011 while small business optimism declined in February to its lowest level in more than a year.

The variable price of oil

February’s inflation readings occurred largely before Russia-Ukraine conflict began. How much of a risk does a higher oil price pose to the U.S. economy? Some have grown concerned that recessions seemingly always follow a spike in oil prices, though that confuses correlation and causation in some past recessions.  

The global oil market entered the conflict suffering through a bit of a supply shock: global oil production remains roughly 3.3 million barrels per day below pre-pandemic levels. Oil production declined during the early stages of the pandemic yet has recovered far more slowly than demand, pushing prices higher.  Moreover, as the world prepared for potential conflict in Ukraine, the price further increased and then spiked once the conflict erupted. Why? Russia exports roughly 5 million barrels of oil per day, a quantity not easily or quicky replaced if sanctions keep it off the market.

Oil prices globally
 

Energy supply needs to satisfy four criteria: secure, affordable, reliable, sustainable (SARS). In recent years the world has increasingly focused on sustainability, but only because the first three criteria were satisfied. But affordability is already deteriorating, and security and reliability are faltering. Meanwhile, global demand for oil remains inelastic, or insensitive to changes in price, because energy is a nondiscretionary need. In the short run, this means consumers will simply pay higher prices for whatever energy they can obtain for their immediate needs. In the long run, it could further incentivize development of sustainable sources of energy, but that will take years. 

An integrated market

Will higher oil prices exacerbate already high inflation? Empirical research shows that when petrostates like Russia engage in belligerent behavior, prices spike, but tend to fall back relatively quickly. Numerous examples of this phenomenon exist over the last 40 years. The current situation already reflects that dynamic – after spiking above $130 per barrel on an intraday basis, WTI oil has already fallen back below $100 per barrel, nearing its price before the invasion began. Ultimately, this should come down to the fate of Russia’s energy exports. If they remain on the global market, no supply shock will ensue, and the oil price spike should prove ephemeral. However, if some or all their exports become excluded from the global market, higher oil prices will persist for longer. This matters because some economic theory suggests that when the price of a good like energy increases, it consequently reduces demand for other goods, leaving inflation largely unchanged. But empirical evidence suggests that it takes extraordinary events to cause outright deflation (usually a recession). 

Yet, we could find ourselves in one of those such events. Demand for goods increased in an unusual way over the last two years as the pandemic caused many people to remain at home. As we move past the most recent wave of the pandemic and warmer weather arrives, we should revert to more pre-pandemic patterns of consumption which should alleviate inflationary pressure on goods. Moreover, despite the structural labor shortage, the cyclical component of the labor shortage associated with the pandemic continues to abate with strong job growth, an increase in labor force participation, and a return of retirees to the labor force. That should help to prevent a wage-price spiral (though in recent decades inflation has pushed wages, not the other way around). 

Disruption derivative

Beyond oil, other potential supply disruptions remain in play. Food supply could get disrupted by the invasion. Other important commodity exports important to technology, such as neon and palladium, could also experience shortages. And the surge of COVID cases in China, the worst since the initial stages of the pandemic, is already causing lockdowns and production shutdowns as China adheres to its zero COVID policy. Right now, the impact of these developments remains unknown, but the risk of all of them line up squarely on the downside.

Fed function

That brings us back to the Fed. Against this backdrop, the Fed will meet this week and will begin to tighten monetary policy, likely with a hike of 25 basis points (bps). With full employment nearly or fully established, they are focusing on price stability with the goal of taming inflation. While the Fed can do nothing about supply constraints, they can tamp down demand to help prevent a bad situation from becoming worse. Ultimately, the underlying capacity growth restrains the Fed’s ability to raise rates and it will struggle to push the Fed funds rate much above 250 bps without triggering a recession, much like the last business cycle. Like most post-war recessions, the risk of downturn now stems from financial conditions tightening too much so the Fed will have to remain circumspect about not going too far as both GDP growth and inflation decelerate. 
 

|  What it means for CRE  |

Commercial real estate (CRE) remains poised to perform well. While some have recently questioned CRE’s ability to hedge inflation, we do subscribe to this theory. The key remains the health of the economy and its impact on the CRE market. The year 2021 proves instructive for this. For the two property types with strong space market fundamentals, industrial and apartment, asking and effective rent growth exceeded inflation. For the two property types with somewhat weaker fundamentals (office and retail) last year, they did not exceed inflation. But we foresee continued growth in the economy which should further support those property types while inflation slows.

|  Thought of the week  |

Cars in the U.S. are roughly 94% more fuel efficient than they were in 1975.