Back to the Transitory Future
What if inflation was transitory all along? Exploring the growing case that the Fed has made sufficient progress.
Just like Doc and Marty did in Back to the Future, let’s hop in the DeLorean and take a drive back in time. It’s July 2021, and Core CPI has just printed 0.80% month-over-month (MoM), the third consecutive month above 0.70%. The three-month annualized rate of core inflation is almost 10%. However, the Federal Reserve (Fed) and the market are only projecting 50 basis points (bps) of rate hikes through 2023, and everyone agrees that the rip-roaring spike in inflation is transitory. Fast forward 18 months to the present and inflation never abated, compelling the Fed to embark on the fastest hiking cycle in modern history. Fortunately, the rapid tightening of monetary policy worked, long-term inflation expectations remained well-anchored, and the monthly Core CPI readings have dropped dramatically. Yet, despite the turnaround, the Fed still don’t feel they have made sufficient progress to stop hiking, they continue to see the risks to inflation as skewed to the upside, and they insist they will need to hold rates above 5% throughout 2023. But what if they’re wrong? What if, after all the handwringing about sticky CPI, it turns out the anticipated decline just took longer-than-expected to materialize? What if, just as the Fed was late to hike because they thought inflation was transitory, they are late to cut because inflation actually was transitory all along?
We’ve now received three consecutive prints of 0.30% MoM or lower on Core CPI, which implies a 3.1% annualized rate, only modestly above the Fed’s 2% target. And, digging deeper, that number is probably overstated. Shelter, which comprises 40% of the core basket, has been running significantly above its pre-covid trend, which skews the basket higher. Given that several leading indicators, such as Zillow and Apartment List, suggest that shelter will moderate materially, neither the Fed nor the market is overly concerned. As a result, if we temporarily ignore housing and instead look at Core CPI ex-Shelter, it shows a deflationary three-month annualized rate of -1%.
Furthermore, while the Fed should rightfully be nervous if the monthly inflation prints are over 0.30%, once shelter start declining, and with goods prices deflating, it becomes increasingly difficult to construct a scenario where the remaining 30% of the basket is inflationary enough to breach that threshold. The Fed has honed in on the services ex-shelter segment because they believe it’s most correlated with wages and has the greatest chance of surprising to the upside, but even these numbers have cooled dramatically: three months ago, the three-month annualized rate was 5.7%, whereas, today, it’s sub-2%.
Given these trends, why should the Fed be so worried? Why do they continue to insist they are hiking above 5% and staying there for the duration of 2023? Core goods price appreciation has proven to be transitory, core services ex-shelter is running below their target, and the housing numbers are lagging what’s happening in real time. Perhaps the Fed doesn’t view three data points as sufficient to signal a trend? That’s fair, but by the time the March meeting rolls around, they will potentially have five benign inflation prints, nearly half a year’s worth. Perhaps the Fed is worried about a tight labor market maintaining upward pressure on wages? That’s also fair, but the pace of payroll growth continues to slow, jobs are becoming harder to find, and more companies are announcing layoffs. Additionally, wage growth, while elevated, has declined materially toward a level that is back within the pre-covid range.
Right now, the market is winning the argument. Despite the Fed’s hawkish rhetoric, rates markets are pricing in a peak funds rate of 4.9% in 2Q23, followed by 85bps of rates cuts through the end of 2023. This goes directly against the Fed’s current mantra of higher for longer and begs the question: why such a divergence? Put simply, the Fed is forecasting inflation over 3% by the end of the year, while the market is closer to 2%. Whereas the Fed is wary about upside risks to inflation, the market sees the most recent inflation trend as sufficient for the Fed to pause and subsequently cut.
So who’s going to be right, the market or the Fed? Using the principle of Occam’s razor, where the simplest solution is usually the right one, we can find the answer:
Just as the market led the Fed up during the hiking cycle, it will lead the Fed down during the cutting cycle.
Just as the leading indicators were correct in predicting the decline in inflation, they will also prove correct in predicting the decline in the labor market.
Inflation was partially transitory. At the onset of Covid, we employed historically accommodative monetary and fiscal policy in response to a once-in-a-generation virus. Nevertheless, the economy re-opened quicker than anticipated, and when coupled with immense supply chain shocks, inflation surged. As these phenomena abated, inflation came down naturally. Add in the fastest tightening cycle in modern history, which will have both cumulative and lagged effects, it seems reasonable to believe that inflation will not only return to target, but if the Fed acts too aggressively, cuts will be necessary to ensure inflation doesn’t fall too far below 2%. A simple regression of inflation against ISM prices paid and supplier deliveries suggests we are well on our way toward this outcome:
Ultimately, the Fed will have to decide when the deterioration in data is sufficient to feel confident that inflation will settle at 2%, because only then will they cut rates. Whether or not they choose to follow the market by cutting in 3Q23 remains to be seen, but by acting too late, they run the risk of tipping the economy into a deeper recession. With data points that can support an array of views, it’s impossible to know exactly what will happen, so buckle up, because just like for Doc and Marty, where the Fed is going, there are no roads.