Inflation is here, and there’s no going back

“Have you seen the price of taco seasoning lately?”

Thus began my most recent conversation with Kelly Brown, CEO of The American Deposit Management Co. (ADM). Kelly admitted she rarely looks at prices in the supermarket, but when she saw a package of taco seasoning priced at $1.79, she was taken aback.

Kelly and I speak frequently, comparing notes on the markets and banks’ appetite for funding. Kelly began her career at US Bank, started a bank of her own, and founded the Commercial Banking School at Marquette University. She knows banking inside and out. During the depths of the financial crisis in 2009, she began thinking about how to build a better corporate cash-management solution, right around the same time that I began thinking about how to create a better solution for individuals’ cash, leading to the creation of Kelly and I were each focused on the same problem: how to help depositors obtain increased FDIC insurance coverage. Along the way, we both found ways to help deliver higher yields as well.

Over the past year, Kelly and I have been fixated on the unprecedented degree of monetary and fiscal support the Federal Reserve and federal government have injected into our economy through PPP loans, Main Street lending facilities, rate cuts, stimulus checks, and infrastructure bills, and what this all means for investors, consumers, and banks. All told, deposits in U.S. commercial banks have risen from $13.3 trillion in January 2020 to $17 trillion as of June 30, 2021. That’s a staggering amount of money, with seemingly more on the way.

In the early stages of the recovery, we saw this new money pour into cryptocurrencies, meme stocks, and NFTs. Then came startling increases in the price of lumber, residential real estate, and used cars. Some of these price increases are driven by supply chain constraints or supply/demand imbalances, but fundamentally, much of the price inflation we’ve experienced over the past year can be attributed to the trillions of dollars of new money pumped into the economy that’s been looking for a home ever since.

What are the consequences of all this new money? First and foremost, this stimulus has proven remarkably successful in preventing our economy from falling into another Great Recession.

COVID-19 dealt our economy a heavy blow, and in March 2020, equity markets predicted Armageddon. Then came government stimulus — lots of it. Through the sheer force of the government’s printing presses (as well as heroic efforts on the part of scientists to create several highly effective vaccines) we seem to have navigated through the worst of the pandemic.

Some households have suffered profoundly. Others have profited handsomely. The K-shaped recovery will be a long-lasting scar from this crisis, further widening the divide between the haves and the have-nots. It’s this latter group that may be disproportionately disadvantaged by the inflationary pressures now sweeping through our economy, having missed out on appreciation in equity and real estate markets just in time to face higher prices for food and rent in perpetuity.

One problem with inflation is it’s self-fulfilling. The mere expectation of inflation can cause inflation, as producers set pricing based on expectations of input costs rising, which in turn causes labor to demand higher pay, which further increases prices. As we experienced in the 1980s, it’s a difficult cycle to break.

All of this cash has also proven problematic for banks. One might think that a surplus of cheap deposits is a good thing, but coupled with a dearth of attractive lending opportunities, excess cash sits on bank balance sheets dragging down returns.

Our economy can’t truly recover until lending replaces the government printing press as the source of liquidity in our markets. The latest quarterly earnings reports show loan growth at the nation’s leading banks has stalled, although many bank executives project it to rebound by yearend.

Thus far, the Fed has shown reluctance to entertain a rate increase, conditioning markets to expect at least another year and a half of zero interest rate policy. But why? With three months of above-target inflation under our belts, how we can be so confident that a rate increase won’t be warranted sooner?

The Fed is tasked with an unenviable challenge: how to keep the economic recovery intact without letting inflation run rampant. If inflationary pressures are indeed transitory, we will have executed a remarkable recovery. If, however, inflation is here to stay, we risk irreparably setting back the financial prospects of the 39% of our population who can’t meet a $1,000 emergency expense, for whom higher prices for groceries or a month’s rent or a used car will represent a significant burden, compounded by the credit card debt and buy-now-pay-later schemes that seem to so disproportionately impact the middle and lower class.

For good measure, or perhaps for good optics, the Fed has added full employment as a secondary but requisite condition before entertaining a rate hike. On the surface, this seems to be a worthy goal, but what if the past 16 months have changed what it means to have full employment?

In the past year and a half, we’ve learned that bank branches are largely unnecessary, that food can be delivered by robot, and in many cases Zoom meetings can be a good substitute for business travel. Is it possible that total factor productivity has increased, such that “full employment” is simply not attainable in the near-term and thus should not serve as justification for a perpetual zero rate policy?

It’s possible our openness to enduring a period of elevated inflation is a deliberate and wise macro policy: devalue our currency to reduce the real value of our foreign debt while simultaneously making our domestically produced goods more affordable for export. Yet for such a strategy to produce good results in the long-term, we must organically grow GDP as well.

Perhaps now is the time to wean ourselves off of monetary stimulus and instead create stronger incentives for banks to lend.

Only then will we know that we’re on a path to a self-sustaining economic recovery, where banks can return to their traditional role of creating the economic liquidity necessary to support sustainable economic growth.

While the price of taco seasoning may be a small leading indicator, a spicy canary in a culinary coal mine, the ripple effects of inflation will be felt throughout the economy if we don’t heed the inflationary warning bells that are already ringing.

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