Even The Inflation Guy Is Scared

Maybe the US Federal Reserve isn’t being panicky, or stupid, but actually sneakily clever.

Whether or not the peak in inflation is getting further away from us, it is increasingly evident that the period of time we will have to wait for “a return to 2% inflation normalcy” is increasing.

As recently as May, my forecast was that median inflation would end 2022 somewhere near 5.2%. That ship has officially sailed. If monthly median CPI averaged only 0.3% for the remaining six months of 2022, Median CPI would still clock in above 5.3%. And median CPI hasn’t had a monthly print as low as 0.3% for a year.

Yes, this week’s CPI was bad. It managed to exceed expectations even though economists have been increasingly raising their expectations.

Last week I showed a month/month chart of the Cleveland Fed’s Median CPI (which is what I focus on forecasting because it is not influenced by outliers like Used Cars, as core CPI is). That chart looked bad. Now it looks worse. The monthly figure would annualize to 9.1%, which is where headline inflation just printed after gasoline prices rose from $3.30/gallon to a recent crest (we hope) at $5/gallon. 

The median is the number at which half of the basket is inflating faster (than 9 percent annualized this month!) and half is inflating slower. It’s scarier than seeing this from core CPI because you can’t point to one thing. Last year, Core CPI rose roughly 0.8% per month in April, May, and June. Remember that? It was due (mainly) to a spike in Used Car prices. Median CPI for those three months averaged 0.28%. So a monthly Median CPI print of 0.7% is much scarier. Here is another way to look at the same phenomenon. The chart below (source: BLS; Enduring Investments calculations) shows in green the proportion of the consumption basket that is inflating at less than a 2% rate; the red line shows the proportion that is inflating more than 10%. You don’t want to see the lines cross in this way.

I was expecting Median to end up around 5.2% this year, and decelerate slightly next year to the mid-4% range. I’m going to be too low for 2022. I fear I will also be too low for 2023. Let me remind you, though, that the inflation market is most assuredly not priced for anything like that outcome. Extracting data from inflation swaps, headline CPI is being priced at 6.4% for 2022, 3% for 2023, and no higher than 2.6% for any year after that. And the breakeven curve is lower than that. Unless you believe firmly that we have a decent chance of deflation or lowflation in the very near future, your fixed-income allocation should be in TIPS. If you hold fixed-rate bonds, you only win if inflation ends up at the Fed target for the next decade. And you don’t win big, even if it comes in a little lower. TIPS are not cheap, but if you have to hold bonds…hold TIPS.

There’s another concerning data point that was released late in the week. The Atlanta Fed’s Wage Growth Tracker, which is in my opinion the most useful measure of wage growth since it is not polluted by compositional shifts, jumped to 6.7% this week. Like Median CPI, it is showing no signs of softening or even topping, yet.

All of this is scary but I realized this week what is even scarier. As I’ve argued before, the Federal Reserve is conducting an experimental monetary policy. Never before has it tried to lower inflation using interest rates alone, without putting pressure on bank reserves. They have models, but they’ve never actually done it. That’s not the scariest part. The scariest part is that the Fed doesn’t know that is it experimenting.

Taking a Step Back…

I haven’t stayed in finance for more than three decades by failing to consider alternatives to my core beliefs. In this spirit: while I’ve been critical of the Fed, let me try to be generous and propose a way that we could interpret Fed actions as in fact quite savvy (if cynical).

The FOMC surely knows, as we all do, that employment is a lagging indicator. The unemployment rate only rises after the economy is slipping into recession. Once the unemployment rate is 0.5% off the lows, you know you’re in recession. There simply aren’t any examples of the Rate rising that much and not seeing a recession. But sometimes, it goes up a couple of ticks, and then goes back down. It takes some time to know, from the employment situation, that you’re in the soup. (It may take even longer this time for that to happen, since there is still a shortage of labor relative to job openings.) But…and this is important…popular opinion about recession tends to be linked to employment. As Reagan said many years ago: a recession is when your neighbor loses his job and a depression is when you lose your job.

Furthermore, the FOMC also knows that inflation will naturally decline on base effects as the year goes along (although we are all less confident of that these days), and headline inflation will almost surely decline unless gasoline prices spike again. 

So if the Committee was really savvy, they might frontload tightening into what looks like a strong employment picture, even though they know that we are either in a recession or will be there soon. It doesn’t look like they are tightening in a recession. And later in the year, when inflation is declining, they can slow down and pretend that it was the result of their actions, claim at least partial victory, and wait to see what happens. If you really believed that it was important to get interest rates up, rather than to restrain the quantity of money, this would be a smart plan to reduce the chance that protesters storm the Fed.

I’m loath to posit such Machiavellian genius from the Committee, but I have to admit it is possible.

Disclosure: My company and/or funds and accounts we manage have positions in inflation-indexed bonds and various commodity and financial futures products and ETFs, that may be mentioned from time to time in this column.