Why the Fed should worry less about sticky inflation (but probably won't)

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When future historians reflect upon the current age, they might call it “the worry years”.?

As America emerges from the pandemic, there are still serious health concerns, a yawning political divide, rising autocracy around the world, a brutal war in Europe and the highest inflation in 40 years.?Moreover, anxiety triggered by these genuine problems is being amplified by cable channels and social media which ever more efficiently gather their audience by appealing to fear and outrage.?

In such an environment, it is perhaps understandable that higher-than-expected inflation has caused the Federal Reserve to lurch from avowed patience to hawkish tightening in less than a year.?Given the outlook for growth and inflation, they would probably be wiser to adopt a less aggressive approach.?However, if, as we expect, they continue to hike rates aggressively both at this week’s meeting and in the remaining two meetings this year, they may well topple the economy into recession.?Such a recession would likely inflict more pain on average Americans than future, diminishing inflation.?For investors, however, it has the silver lining that it could, in time, result in a return to the slow-growth, low-inflation, low-interest rate environment that has supported both the bond and stock markets for many years.

Last week was a very rough one for markets.?The S&P500 fell by 4.8%, the nominal 10-year Treasury yield rose by 12 basis points to 3.45%, the 10-year TIP yield climbed 16 basis points to 1.07% and the 2-year Treasury yield rose by 19 basis points to 3.85%, its highest level since 2007.?

The generally accepted reason for all of this was that CPI inflation came in “hotter-than-expected” and, consequently, the Federal Reserve is now expected to raise interest rates even more aggressively this week and in the months to come.

However, it is important to have a clear, long-term perspective on the inflation story, how the Fed should react to it and how the Fed is likely to react to it.?

• First, inflation pressures are diminishing – just not quite as fast as the Fed would like to see due to sticky factors such as wage inflation, inflation expectations and shelter costs.
• Second, examined one-by-one, there are good reasons why the Federal Reserve should not over-react to these sticky elements of inflation, and,
• Third, investors need to distinguish between what the Fed should do and what the Fed will do.?A reasonable forecast of the latter suggests a better outlook for financial markets than the economy.

August CPI: A small miss to the upside in a downward trend

In May, headline CPI rose by 1% and in June it jumped by a further 1.3%, putting the seasonally-adjusted year-over-year increase at 9.0%[1] , its fastest year-over-year pace since 1981.?However, since then, inflation has eased.?Consumer prices were flat in July and rose just 0.1% in August, with the year-over-year inflation rate falling to 8.2%

Despite this trend, markets reacted badly to last Tuesday’s CPI print, as inflation exceeded the - 0.1% consensus expectation.?The details of the report were disappointing.?In particular, the modest 0.1% print for the month was almost entirely explained by a 10.5% decline in gasoline prices.?Elsewhere, there were plenty of hotspots with food and new vehicle prices both rising by 0.8%, electricity prices climbing by 1.5% and shelter costs rising by 0.7%.?

In the short run, year-over-year inflation seems set to fall further.?

• Gasoline prices have continued to slide with a gallon of regular unleaded gasoline selling for $3.68 on September 18th, compared to an average of $3.97 in August.
• Food prices, which showed sharp gains in August, should rise more slowly in the months ahead, reflecting softer consumer demand and reduced transportation costs.
• Used car prices, which fell by 4.6% in August, could fall further as used-vehicle inventories return to more normal levels.

Overall, we currently expect CPI to rise by 0.2% in September, cutting the year-over-year rate to 8.0%.?Monthly readings may be a little stronger thereafter.?However, for the fourth quarter overall, we expect year-over-year headline CPI inflation of 7.1%, falling to 3.1% by the fourth quarter of 2023.?The Fed’s preferred measure of inflation, the personal consumption deflator, normally runs a little cooler than CPI and appears to have peaked at 6.8% year-over-year in June.?We expect PCE inflation to fall to 5.1% in the fourth quarter of this year and 2.4% by the fourth quarter of 2023.

It is important to emphasize that this prediction is based on what we know today.?Other factors, such as an escalation or de-escalation of the Ukraine war, how China eventually handles Covid, weather events or other issues could all radically impact the short-term inflation outlook as they have in the recent past.

Too sticky for the Fed’s comfort

With all these caveats, this does show steadily falling inflation and is close to the median projections made by the Federal Open Market Committee in June.?In addition, for a Fed targeting 2% inflation, going from 6.8% year-over-year in June to something between 2% and 3% by the end of next year would seem like major progress.?

So why is the Fed so anxious to tighten aggressively?

One reason is that members of the Fed, like other central bankers, generally see their first duty as preserving the value of the currency.?When inflation gets out of hand, they generally take the blame.?This is not fair in this case – U.S. inflation was overwhelmingly caused by the pandemic, the fiscal response and Russia’s invasion of Ukraine.?However, both the Fed itself and financial commentators are willing to blame the Fed for inflation and demand a response.?

Second, the Fed is concerned about “sticky inflation”.?In particular, while headline inflation should fall sharply in the year ahead, the Fed is worried that core inflation, which excludes the volatile food and energy categories, could remain elevated.

One aspect of this is “inflation expectations”.?In his recent Jackson Hole speech, Chairman Powell opined that history teaches us that “the public’s expectations about future inflation can play an important role in setting the path of inflation over time”.?

This probably is less true today than it was back in the 1970s. Today, workers may feel they deserve a raise but without union organization, they may have a hard time getting one.?Equally, attempts by any business to raise prices don’t work as well when consumers can, in an information age, instantly see the prices of their competitors.

Still, even if the Fed were right to be worried about inflation expectations, current data are not that scary.?According to the University of Michigan Consumer Sentiment Survey, consumers expected 2.8% inflation over the next five years in early September.?The expected CPI inflation rate over the next five years embodied in the gap between yields on nominal Treasuries and TIPS was 2.49% on Friday.?Finally, the median expectation of average CPI inflation rate over the next four and a half years according to the Philadelphia Fed’s August survey of professional forecasters is 2.8%.?None of these numbers are high, all of them are falling and all of them are likely to fall further as the economy and actual inflation soften in the months ahead.

A second problem, in the Fed’s view, is wage inflation and the Fed appears to believe that the current unemployment rate of 3.7% is too low to stabilize wage growth.?

Again it is hard to get too enthusiastic about any mission to boost unemployment as a way of slowing inflation.?For one thing, the actual unemployment rate at 3.7% is not far from the 4.0% that FOMC participants profess to believe is consistent with stable inflation.?Second, year-over-year wage growth has fallen from 5.6% in March to 5.2% in August and is well below goods and services inflation.?For decades economists have lamented rising inequality and a primary cause of this has been a falling wage share of GDP.?A tight labor market is putting a dent in this, temporarily, and it seems strange to watch the Fed move so aggressively to snuff this out.

And then there is the issue of shelter inflation.?All told, shelter accounts for 32% of CPI and shelter inflation has been rising relentlessly, reaching a 40-year high of 6.3% year-over-year in August.?

Shelter inflation is undoubtedly sticky.?The CPI for rent is supposed to measure the average rent paid on both new and existing leases.?Thus if there is a sudden spike in market rents on new leases, such as has occurred since the spring of 2021, it only feeds slowly into rent CPI as old leases are replaced by new ones.?Even if the rent on new leases were to move sideways from here, CPI for rent would continue to rise for some time.?Moreover, generally low vacancy rates suggest that we are some distance from any significant decline in rents on new leases.

This will continue to have a major impact in sustaining inflation over the next year or two.?However, even here, it is important to maintain perspective.?While rising actual rents are a great hardship for families renting houses and apartments, actual rent only has a 7% weight in the CPI basket.?Far more important in CPI is owners’ equivalent rent which accounts for 24% of the index and which represents the rent a home-owner would pay if they rented rather than owned their home.?

This series tracks actual rent closely and will be largely responsible for the stickiness of core inflation in the year ahead.?Indeed, while we expect CPI ex food and energy to be up by 3.3% year-over-year in the fourth quarter of next year, we project that shelter will be up 5.6% and that CPI ex food, energy and shelter will be up just 1.8%.?Eventually, of course, cash-strapped households will balk at rent increases while the supply of multi-family housing should get closer to demand.?But in the meantime, is it worth putting the economy into recession to fight a core inflation problem which will be largely due to the stickiness of inflation in owners’ equivalent rent - a category of inflation that no one actually experiences?

What the Fed should do and what the Fed likely will do.

Despite heated rhetoric, a dispassionate view of U.S. inflation prospects suggests that the Federal Reserve should back off a bit on their aggressive tightening path.?That is not to say that inflation isn’t a problem – it is a severe one for households living from paycheck to paycheck.?However, one thing worse than living from paycheck to paycheck is trying to live with no paycheck at all.?With inflation cooling on its own, there is no reason for the Federal Reserve to push the economy into recession just to reach their inflation target faster.

Moreover, a key reason why the Fed should raise rates slowly is that they could reduce imbalances in both financial markets and the economy if they were able to maintain more normal positive real interest rates in the long run – something they probably won’t achieve if they feel the need to respond to a recession in 2023.

As for what the Fed will do, slightly higher-than-expected inflation in August probably locks in a 75 basis point rate hike this week, with Jay Powell making it clear that the Fed could so the same in November.?If they do this, and then follow with a last 50 basis point hike in December, the federal funds rate will end the year at between 4.25% and 4.50% - two full percentage points higher than today’s level.

At that point, the Fed may well pause to see how the economy handles higher rates.?They probably won’t like the answer, as high mortgage rates and a high dollar hurt housing and exports respectively and fiscal drag continues to slow consumer spending.?The truth is, the outlook for the economy in 2023 is for very slow growth at best.?Further aggressive Fed tightening may push it over the edge.

If this happens, it will entail the usual recessionary pain for laid-off workers and their families as unemployment rises.?However, such a recession would likely snuff out any remaining inflation and a combination of low inflation and recession could prompt the Federal Reserve to cut rates later in 2023.?While this would do little to spur investment or consumer spending, it could lead to a return to the slow-growth, low-inflation, low-interest-rate environment that prevailed over most of the second decade of this century.?As such, it would be an uninspiring environment for families but could be a very profitable one for investors willing to put money to work today.

[1] By convention, the Bureau of Labor Statistics highlights non-seasonally adjusted year-over-year changes in its CPI press releases.?We believe that this is inappropriate as both trend changes in seasonality and the timing of public holidays impact the seasonal behavior of CPI and, to a small extent, year-over-year changes.?Consequently both here and in the Guide to the Markets, we reference year-over-year changes in seasonally-adjusted data.

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