by Chris Kuehl, managing director, Armada Corporate Intelligence

Somehow, I’ve always wanted to connect my musical past to economics. Well, maybe I just decided this minute to make that link, but it seems appropriate to reference this when talking about an economic issue we have not faced in a long time. A cloud has been on the horizon for quite a while, but of late it has started to look a lot more menacing and imminent. We are heading toward an inflationary period of significance, and this is not something that many of us have experienced over the better part of the last two decades – we have been busy contending with a recession and then a very slow recovery from that recession.

It would be a good idea to review what inflation actually is, how it is assessed and why it worries economists far more than a recession does. Simply stated, an inflationary period is one in which prices of most everything rise – and generally sharply. These price hikes vary and rarely proceed in lock step: There may be inflation in one sector and even deflation in another but, as the problem worsens, the inflation broadens. The deepest concern among analysts is when there is inflation in the most basic of commodities, as these prices soon course through the entire economy.

The rate of inflation is measured by noting the change in pricing from one period to another – an annual rate, monthly or quarterly. The annual measure is generally the most reliable, as it limits the impact of volatility in pricing. There are generally two types of inflation measures – core inflation and real or headline inflation.

The measurement of core inflation often drives people nuts, as the economic analysts who do these numbers do not consider the price of fuel and food. These are arguably two of the biggest factors in a given family’s budget, and it doesn’t seem to make any sense at all to not consider the price change. The measure of real (headline) inflation does indeed count both food and fuel. The reason they are not considered as part of the core rate is that these prices are extremely volatile and can change radically within a few weeks. That makes it very hard to make comparisons over a few months or a year. It also is assumed that these price hikes will show up in other ways through the course of the year – higher transportation costs, higher air fares, more expensive restaurant meals and so on.

When it comes to driving up prices, the two most important factors are commodity prices and labor. When there is a rise in the price of oil or natural gas, there is a sharp response in utility costs and the price at the pump. Drivers feel it, transportation providers feel it and consumers feel it when they pay more to heat and cool their homes. Industrial metal prices, plastic resins, chemical compounds, lumber and cement are among the many other commodities that form the basic building blocks of the economy.

Then, there are wages. For the last year or so, the expectation has been that wages would go up at any minute, as all the conditions were right for such a hike. There is a theory called the Phillips Curve, which has been in place since the 1950s, that made the connection between low levels of unemployment and higher wages. Naturally enough, it was assumed that when there were fewer people available to hire, the business community would have to pay people more to get them to take the jobs on offer. It also was assumed that companies would poach from one another to get the people they needed – and, that also meant higher wages to lure people to change jobs or higher wages to get people to stay right where they were.

Some movement in commodity prices did occur, but not all of them rose as quickly as expected. Commodity prices have been increasing for both natural and artificial reasons. The natural reason is that producers reduced their output when demand faltered, and output has been slow to return to prior levels. The artificial motivation has been the tariff and trade war launched by Donald Trump. This has driven up the price of steel and aluminum, and various threats directed toward the Iranians and others have pushed the oil markets to hike prices.

Wages did not go up as predicted, as those looking for work lacked the skills and training needed. If they did get hired, it was with the understanding they would need to be trained and would not be making much more than minimum wage until they had the needed skills. Businesses have started to give up on finding qualified people and are hiring attitude and assuming the need to do their own training.

One very important factor we have not talked about yet is the role of the Federal Reserve. The job of the Federal Reserve is to manage monetary policy, which means intervening when there are recessions and inflationary periods. In truth, the central bankers are far better equipped to deal with inflation than they are with recession. The only weapon the Reserve has to goose the economy along is to make money cheaper by lowering interest rates and finding other ways to get banks active. This has been referred to as “pushing a string,” because banks can’t be compelled to loan – they have to want to and, during a recession, they often don’t. Controlling inflation, on the other hand, is far easier. All the Fed has to do is make money harder to get by hiking interest rates and reducing the availability of bank assets, which is accomplished by setting the reserve ratio or changing the interest rates the banks get for depositing money at the Fed.

In the most general of terms, the Fed is made up of “hawks” and “doves,” but the designations are highly flexible depending on how the data are trending from one month to the next. The hawks want interest rates higher and worry far more about inflation than do the doves, who think the recession threat is the more damaging.

Right now, the hawks seem to hold the majority position within the Fed’s Open Market Committee (FOMC) – the body that is charged with setting these rates. The members this year include Jerome Powell as Fed Chair and John Williams as the head of the New York Fed and Vice Chair. They are joined by the other seven permanent members of the Board of Governors and four of the regional bank heads who rotate for annual terms. Right now, there are only three members of the board: There have been some resignations and retirements, and the replacements have not worked through Congress. Of the three, Powell, Randall Quarles and Lael Brainard are swing votes – hawkish on inflation now but shown to be more dovish in the past. The four regional heads that are on the FOMC this year include the very hawkish Loretta Mester from the Cleveland Fed, John Williams from New York, Raphael Bostic from Atlanta and Thomas Barkin from Richmond. The last three named have been both hawk and dove at times but are hawkish now.

All this means the Fed will be quick to raise rates to contend with any sort of inflationary threat. Obviously, it has already started with the rate hikes this year and the stated desire to raise them again in September – and, likely in December as well. The assertion is that rates would go up four more times in 2019. The Fed Funds Rate now is 2.0% and will likely be at 2.5% by the end of the year. If current thinking prevails, the rate at the end of 2019 will be between 3.0% and 3.5% – but that assumes inflation stays below 2.0% at the core level, and many are suggesting this will be a hard line to hold.

Our fearless forecast holds that core inflation will climb to at least 3.0% in the next 12 months, and this will provoke the Fed to hike its rates faster than anticipated. We are looking at interest rates between 3.5% and 4.5% by the end of 2019.

Chris Kuehl is managing director of Armada Corporate Intelligence. Founded by Keith Prather and Chris Kuehl in January 2001, Armada began as a competitive intelligence firm, grounded in the discipline of gathering, analyzing and disseminating intelligence. Today, Armada executives function as trusted strategic advisers to business executives, merging fundamental roots in corporate intelligence gathering, economic forecasting and strategy development. Armada focuses on the market forces bearing down on organizations. For more information, visit www.armada-intel.com.