Night of the Living Fed
CFA & Evan Olonoff
The Fed’s view that inflation would be transitory has turned into a horror movie. We flag several risks that suggest the Fed might now be making more progress than it thinks.
When the US Rates team isn’t analyzing the bond markets, we love to discuss movies. And with Halloween around the corner, we’ve been tossing around our favorite horror films. What we noticed is that they all have one thing in common: characters ignoring obvious warning signs, which ultimately results in their demise. Coincidently, we’ve also been debating whether the Federal Reserve (Fed) is treading down a similar path by ignoring some compelling signals that inflation is about to turn lower. If that’s the case, using only backward-looking CPI data to determine the Fed Funds Rate may prove fatal for the US economy. There is no doubt that forecasters have underestimated the magnitude and stickiness of inflation. The below comments, however, examine certain dynamics in the global economy that suggest the decline may actually be around the corner.
How did we get here?
For the last eighteen months, the Fed has been haunted by stubbornly high inflation. What started out as a temporary shock related to COVID-induced imbalances has morphed into the most severe and prolonged period of high inflation in forty years. Back in the middle of 2021, Fed Chair Powell was adamant that high monthly inflation readings were transitory, that monetary policy could remain dovish, and that rate hikes were not necessary yet. Since then, Core CPI has increased at an average of over 0.50% per month, which is an annual pace of 6%, 4% above its target. And not only have inflation readings been high, buy they’ve been remarkably stable. The 6-month moving average of Core CPI has stayed above 0.40% for 16 consecutive months. Ultimately, core inflation remains stubbornly high due to 2 factors: 1) Service inflation, including shelter, continues to accelerate and 2) goods inflation has not been decelerating as quickly as anticipated.
Where does inflation go next?
Since the Fed began its pivot a year ago from the most dovish in history to the most hawkish in 40 years, it has lost all confidence in its ability to forecast inflation. This has forced them to drop virtually all forms of forward guidance, and the result is a myopic focus on each monthly inflation reading. Conducting monetary policy by looking only in the rear-view mirror, the Fed hopes to convincingly crush inflation by remaining hawkish until the trailing inflation prints show enough progress towards 2%. For a central bank that is as spooked as the Fed, this might seem like a prudent strategy, particularly if it’s meant to prevent a 1970’s style inflation shock, which lasted more than a decade and resulted in stop-start policy decisions. However, by setting policy using only trailing data, the Fed ignores the fact that monetary policy impacts the economy with a lag and that inflation typically decelerates AFTER the economy is already in a recession. For example, after the Global Financial Crisis in 2008, core inflation didn’t trough until 2 years later.
This begs the question: what if the Fed is making the same mistake it made a year ago, only in reverse? In its attempt to overcompensate for making a dovish policy error in 2021, could the Fed be overtightening in 2022 despite real-time evidence that the inflation fever might be breaking? In recent months, a mosaic of leading indicators has changed direction and is now signaling that disinflationary forces may be starting to take hold in the economy.
- There is preliminary evidence that wage growth is moderating. The monthly pace of Average Hourly Earnings peaked earlier this year and has since decelerated to a run-rate that isn’t far from where it peaked in the last two cycles. Additionally, fewer small businesses are planning on raising wages and job openings are starting to come down.
- Global supply chains appear to be healing. Wholesale and import prices are declining, commodity prices have fallen, supplier delivery times are shortening, inventory levels are normalizing, and shipping rates are cheapening.
- This dynamic most directly impacts the goods sector as healing supply chains, falling commodity prices, and a shift toward service spending has resulted in the start of a visible cooling of goods prices.
- Additionally, the fall in industrial and agricultural commodity prices since the spring will help moderate food and energy inflation, as well as serve as a suppressant on various non-commodity sectors, such as airfares and restaurants.
- There are also signs the housing market has started to cool with real-time readings of rent growth for new leases decelerating back to pre-COVID trends, which bodes well for Shelter CPI. That said, it is incredibly difficult to know when this weakness will feed into the official government data.
- Lastly, due to quirks in the way that Health Insurance CPI is calculated, it’s highly likely that this component will fall in price over the next 12 months after having been a massive contributor to Core CPI over the last year.
Taken all together, we can point to a plethora of subcomponents within the CPI basket that should be moderating.
Unfortunately, for the Fed, the last eighteen months have proven it’s important to be humble when forecasting inflation. Indeed, the Fed’s own humility has resulted in a purely data-dependent reaction function where forward looking indicators of inflation are effectively ignored in favor of emphasizing the trailing readings. And this has implications for markets: if they continue down this path, it ultimately means a slower response to weakening data, a greater risk of an even higher terminal rate, and a higher probability of larger and faster cuts down the road. They could always pivot away from this strategy, but if they choose to ignore the signs like our favorite horror movie characters, their efforts to stomp out inflation run the risk of overtightening policy and pushing the economy toward a hard landing.