Also authored by, Morgan Dipo, SVP, Commercial Banking, Bank of America
Inflation is in the news again after a hiatus of several decades. Consumers are experiencing increases in the cost of living in many segments of their monthly spending, and it is changing how they spend and how businesses keep up with uncertainty in pricing.
As measured by the Consumer Price Index (CPI), consumer prices as a whole increased by 7 percent across all categories in 2021. This is the highest increase since the late 1970s, when inflationary increases peaked at 13.5 percent in 1980. Some commentators say that today’s inflation might exceed that of 40 years ago due to the differences in how the indices were calculated. The Producer Price Index, a precursor to consumer prices, rose 9.7 percent in 2021, presaging the possibility of even greater inflation rates to come during 2022.
A sampling of segments yields the following:
- Gasoline prices increased 49.6 percent
- Used autos and truck prices increased by 37.3 percent
- Shelter expenses rose 4.1 percent (although it is widely believed that this is understated with leases rolling off on a monthly basis)
- Grocery prices increased 6.3 percent
(Sources: Bureau of Labor Statistics, Wall Street Journal, CNBC)
Offsetting some of these increases, materials costs — after experiencing a sharp run-up when the economy mostly opened up — have generally declined over the past few months. Service costs have increased as well.
BofA Global Research expects inflation to remain well above the Fed’s advertised 2 percent target throughout 2022, with core PCE to settle around 2.4 percent and core CPI around 4 percent year-over-year by the fourth quarter. This is driven by transitory pressures (related to the pandemic and reopening) that will continue to be a theme this year but also by persistent inflation pressures such as growing wages (in part due to the slow return of labor supply) and inflation expectations that contribute to a feedback loop.
The Fed faces a challenge to bring inflation under control delicately so as to not short-circuit the business cycle and allow for a soft landing, which BoA Global Research believes will lead to 7 rate hikes in 2022 starting with the March meeting, followed by another 4 hikes in 2023, to end with a terminal rate of 2.75-3 percent.
WHAT DOES THIS MEAN FOR CONSUMERS AND BUSINESSES?
Consumers in the lowest income brackets will be affected the most. With energy, shelter and food costs increasing, availability of disposable income for entertainment, larger capital purchases, education and other expenses will be reduced and will put a damper on economic activity. For some, there might even be a need to curtail spending on necessities.
For wage earners, an increase in salaries and hourly wages will be needed to keep up with price increases or their purchasing power will decline. Those on fixed incomes will be particularly hard hit.
This is likely to filter throughout the entire economy. On the supply side, increases in energy costs, for example, will increase the cost of nearly everything that is manufactured and consumed. On the demand side, certain demographics of consumers will purchase less, which will impact business revenues and profits. Coupled with input and wage cost increases, some businesses will be severely impacted by the effects of inflationary behavior and the risk of failure will increase.
The worst possible combination of economic trends — both inflation and recession — have the potential to lead to stagflation. Stagflation comes about when cost pressures and inflation expectations spiral higher and create a price feedback loop that results in a sustained shock to real estate activity and aggregate demand. While that has yet to be observed in the economy, there are warning signs (manufacturing activity declines reported in January, for example) of this possibility.
WHAT DOES THIS MEAN FOR BORROWERS?
While the Fed’s mandate is to target Fed funds, typical rate indices that loans are based on (such as secured overnight financing rate, or SOFR) have a correlation and hold special significance right now in light of the transition away from LIBOR (London Interbank Offered Rate).
Simply put, unhedged borrowers can expect to pay more in interest this year if the Fed follows market expectations. All borrowers would be wise to consider their own business expectations, debt levels, maturities and other factors when discussing with their banks and other advisors how to best manage inflation and interest rate risks in 2022 and beyond.
WHAT DOES THIS MEAN FOR FINANCIAL AND M&A MARKETS?
Inflation typically leads to less consumer purchasing power and reduced profits for companies, and higher interest rates (one major tool to combat inflation) can exacerbate those problems. However, an increasing rate environment is also an indicator of a healthy economy as the Fed tries to fulfill its dual mandate of maximizing employment while keeping prices stable.
For transactional activity, there is growing concern that a slowdown in economic activity will occur. With overall economic activity decreasing its rate of growth (or turning negative) coupled with rising borrowing costs (interest rates), financial buyers will likely demand lower multiples and insist on more structure to transactions to accommodate if these trends play out (see Earnouts in the Age of COVID for discussion).
Sellers will adjust their expectations, but there will be a lag— thus reducing the number of deals concluded. Given the above trends, as sellers adjust expectations, lower growth and less profitability could add to many potential sellers pulling their company from the transactional market.
CONCLUSIONS
With the danger of inflationary trends, it is only a matter of time until the Fed intervenes to raise interest rates to combat these developments. Indeed, the Fed has already signaled several modest rate increases during 2022 to the markets. If inflation data show signs of running even hotter, the Fed may involve itself even more. Large increases in interest rates could derail the current economic recovery and have a dampening effect on all types of economic activity.
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