May 17, 2023 – Since early 2022, the Federal Reserve has been raising its policy interest rate at breakneck speed by a full five percentage points. Inflation has indeed subsided a bit, but both price levels and percentage changes remain stubbornly high. When will inflation finally go back to normal? What’s the path forward for monetary policy? Will there be a recession? So many questions! Let’s take a look…
Transitory vs. Permanent Inflation
I wanted to quickly bring up one issue that I believe is the source of a lot of confusion: the concept of transitory vs. permanent inflation. Is the 2021-2023 inflation shock transitory or permanent? It’s both! That’s because it depends on whether we look at CPI index levels or CPI year-on-year inflation rates. In the chart below, I plot the CPI (headline) index levels, i.e., the price level normalized to 100 for the 1982-1984 period. The most recent index reading is 302.918. If I had extrapolated a 2% p.a. post-2019 before the pandemic hit, then the index would be well below, at around 276. The actual CPI is now about 10% above that dotted trendline, which means we likely suffered a permanent 10% bump in prices (and likely more to come!).
Sorry to be the bearer of bad news, but not only will we likely never reach the old 2019 prices again, but we might also stay permanently above even the 2019 levels plus a 2% inflation trend. There is nothing transitory about that shock unless we believe that, over the next 2-3 years, we’d have significant deflation(!) to bring that CPI level down to the post-2019 trend line. As bad as the inflation shock may be, we probably don’t even want to go back to the pre-pandemic trend line because extended deflation like that is probably the effect of a major recession or even economic depression. Permanent inflation might be the smaller evil!
How about inflation rates?
The best we can hope for is that the growth rate of CPI will approach its long-term average of about 2% per annum again so as to not further diverge from the pre-pandemic inflation trend. But even that looks like a bit of a stretch right now. Annual inflation rates are still well above that magical 2% line; see the chart below. That said, we’ve made some progress toward reaching that 2% target again, at least if measured by headline inflation. Headline CPI peaked at 9%, now at 4.9%. Headline PCE peaked at 7%, now running at 4.1%. Hey, we’re more than halfway there! Also, notice that CPI numbers are available up to April 2023 and PCE only up to March. We expect the April figures on May 25, likely showing another small decline.
But here’s the bad news: despite some progress in the headline inflation numbers, core inflation is still stubbornly high. 12-month Core CPI peaked at 6.6% in September 2022 and is now only about a percentage point below that. And Core PCE, the FOMC’s preferred inflation gauge, peaked at 5.4% more than a year ago and still runs at 4.6% over the last 12 months. Even with inflation rates, we still seem a long distance away from getting back to normal and calling this pandemic inflation shock transitory. This brings me to the next question…
When will inflation subside again?
The worst-case scenario would be a permanently higher inflation rate. A recent WSJ article noted how rapid price increases might have become “entrenched” and how this might soon become a self-fulfilling inflation spiral. The good news is that the inflation picture isn’t quite as bleak as some folks want to make it. While the WSJ article makes some interesting points, there are also a number of trends underway that will soon put a dent in the inflation numbers. Hopefully!
First, the PPI (producer price index) is already almost back to 2% year-on-year; please see the chart below. Think of the PPI as the upstream inflation pressure, probably leading the CPI and PCE by about 3 months. And further, notice that this moderation in price pressures is broad-based. It’s not just due to energy prices; even the Core PPI fell from close to 10% at the peak in early 2022 to just above 3% in April 2023. So, the PPI headline is already where we need it, and the PPI core is already about 90% there. That’s some progress!
So, with the upstream price pressures abating, there is some hope that we, the consumers, will eventually feel the effects downstream as well. This artifact of final output prices declining only very sluggishly after input prices have already fallen even has a name in economics: “Rockets and Feathers,” which is often observed in retail gasoline prices. The price you pay at the pump goes up immediately when crude oil prices and wholesale gasoline prices rise (=the rocket). But on the way down, gas stations are lowering prices only very sluggishly (falling slowly like a feather). So, gas stations try to milk the high retail prices as long as possible, and this creates the intriguing fact that gas stations actually generate the highest profit margins when gas prices are on the way down. I suspect that we are now experiencing this “feathers” principle on an economy-wide scale. It’s not a huge surprise because this rockets and feathers effect has indeed been documented more broadly, not just in gasoline prices. So, it may be frustrating, but I suspect this effect is one of the reasons why the stock market has been holding up relatively well. Profit margins are very healthy right now, with strong final goods prices and input inflation back to normal. So, if you own stocks, take solace in the fact that you benefit at least a little bit from the ripoff at the pump and everywhere else in your consumption basket. And enjoy it while it lasts because, eventually, competitive forces will drive down prices again!
The second reason to be optimistic is that the next two CPI data releases for May and June 2023, to be published about mid-month in June and July, respectively, will likely show significant improvement, at least in the headline numbers. I wouldn’t be surprised if the year-over-year CPI took a significant nosedive over the next two releases because we’re rolling out the very strong price shocks in May and June of 2022 and replacing them with more normal monthly CPI changes. Expect a reading in the low-4s in the report next month (Update 6/13/2023: actual YoY CPI indeed came in at 4.0%!). And by mid-July, when the June numbers are published, we could already observe a headline CPI number well below 4%. Probably somewhere around 3.5% and maybe even 3.3%.
The third reason has to do with rental inflation. Rents are another culprit for inflation being so sluggish on the way down. Rents are not set like gasoline prices or prices at the grocery store but rather very infrequently because rents are normally fixed for an extended period, often a year. The impact of this price sluggishness (also called “price stickiness” in economics) is apparent in the chart below, where I plot CPI and a few of its components. Note how the rent component seems to have an almost one-year lag vis-a-vis the overall CPI curve. For example, CPI had its pandemic trough in May 2020, but it took the CPI-rent another 11 months, until April 2021, to hit its low. Likewise, the overall CPI had its peak in June 2022, while rental inflation is only recently leveled off. Rental inflation, with its large share in core inflation, had been rallying over the past few months while some other components started to ease already. If rental inflation finally keels over and follows the economy-wide downward trend, we should see major improvements in the CPI and PCE numbers. Notice how CPI-less-shelter is already down to below 4% right now.
I also looked up the forecast of the 5-year average inflation rate implied by TIPS rates, i.e., the difference between nominal and real U.S. government bonds, and the rate is now down to 2.13% (as of May 16, according to Bloomberg.com). Financial markets certainly believe that inflation won’t be lingering too far above 2% for too long!
Also, very noteworthy, food and beverage inflation is finally taking a nosedive as well. It’s good news for households with lower income who have been disproportionally impacted by the outrageous surge in grocery bills. Food inflation is also sluggish, not so much because of price stickiness but because of production lags due to agricultural growing/breeding cycles. And finally, medical goods & services, another heavyweight in the CPI, is also on a nice downward trajectory.
Who knows, maybe once rental inflation starts heading down, we’ll start worrying about disinflation again. This may explain why the Federal Reserve’s FOMC has slowed its rate hikes and may even pause at the upcoming meeting. And this also brings me to the next topic…
Monetary Policy
When I’m commenting on monetary policy, I’m always walking a fine line. If I’m too critical, people accuse me of having sour grapes with my former employer. If I’m too nice, people accuse me of being one of those evil central bankers peddling worthless paper money to unsuspecting Americans. So, let me start by stating that under the circumstances of being a little bit late with tightening monetary policy, the FOMC has so far done a pretty good job of raising rates and nudging CPI on its downward trajectory. If CPI and PCE decline as planned over the next few months, it would be quite an accomplishment for the Fed to thread the needle and bring down inflation without wrecking the economy, Paul-Volcker-style.
But not all is well in Fed-land. I’m worried about the Fed eventually messing up and snatching failure from the jaws of victory. I’m getting the impression that Fed officials are way too obsessed with the labor market and way too fixated on the impact of the unemployment rate on inflation. I went to graduate school to get my Ph.D. in economics in the late 1990s, and the Phillips Curve was dead back then. Who resurrected that rotting dead corpse in the meantime? True, nobody uses the old-fashioned Phillips Curve anymore, i.e., the level of unemployment correlates with the level of inflation. The newer iteration of the Phillips Curve comes in the shape of the NAIRU (“Non-Accelerating Inflation Rate of Unemployment”) concept, where the unemployment gap (actual vs. “natural” unemployment rate) is negatively correlated with the change rather than the level of the inflation rate. Applying this concept to today’s environment, the unemployment rate at a multi-decade low of 3.4% will create upward pressure on the inflation rate.
The NAIRU certainly has some intuitive appeal because low unemployment might create wage pressures and even raise inflation. But empirically, the NAIRU has been utterly debunked. Historically, the NAIRU has been so bad at predicting inflation that a naive random-walk forecast of the form “next year’s inflation = last year’s inflation” has a lower out-of-sample forecasting error than the NAIRU with all bells and whistles, as two of my former professors demonstrated. In fact, the recent decline of all the CPI, PCE, and PPI measures, all while unemployment is so low, demonstrates that the NAIRU is unreliable. Core inflation is so sluggish because of the rental inflation lags, not because of the labor market.
But the NAIRU voodoo economics is alive and well at today’s Federal Reserve. Read the speeches, press conferences, and testimony of FOMC members; they almost always tie inflation expectations to unemployment. For example, Governor Michelle Bowman, at a recent conference:
“Should inflation remain high and the labor market remain tight, additional monetary policy tightening will likely be appropriate to attain a sufficiently restrictive stance of monetary policy to lower inflation over time. I also expect that our policy rate will need to remain sufficiently restrictive for some time to bring inflation down and create conditions that will support a sustainably strong labor market.”
Michelle Bowman at a confrence in Germany. Source: Federal Reserve.
It’s almost like the FOMC misremembered the old and still valid Milton Friedman quote, “Inflation is always and everywhere a monetary phenomenon,” and now pins all the inflation dynamics on the labor market.
My concern is that the FOMC might cast aside all evidence on potentially moderating inflation in the coming months and feel the need to do more monetary tightening and/or keep rates high for longer than really needed, all to raise the unemployment rate. The danger is that they won’t believe their “lying eyes” on moderating inflation and rather manufacture a recession when they could have just sat back and lowered inflation without causing such harm.
There is certainly a great divide between market expectations and the FOMC “dot-chart” median path for the Fed Funds rate; please see the Fed Funds Rate expectations chart below. Futures markets predict declining rates much ahead of the FOMC’s expected timeline. Noted, the FOMC updates this chart only every second meeting, so this is still from the March 2023 meeting. But Chairman Powell, at the May 3 press conference, reiterated his view that there will likely be no rate cuts in 2023. I doubt that this chart will change much at the next release on June 14.
So, let’s all hope that rental inflation finally drops in the coming months. Otherwise, the FOMC could be on a collision course with financial markets and the economy. Talking about the economy brings me to the next topic…
How’s the economy doing?
Knock on wood; the economy seems to be holding up so far. After a recession scare in early 2022 with two back-to-back quarters of negative growth (but no official recession declared), GDP has been growing again for three quarters in a row (Q3 2022 to Q1 2023). The second-quarter GDP reading will come out in late July, but that, too, is shaping up positively, with the Atlanta Fed GDPnow model currently tracking at 2.6% (as of 5/16/23).
The three business cycle indicators I always like to monitor are:
1: The Yield Curve Slope. That indicator looks scary! I use the 10-year minus the 2-year Treasury yield, and that’s currently at -0.52% (5/16/2023). In the past, an inverted yield curve has always signaled a recession. Not a good sign, I know, but this is what you get when the Fed raises short-term interest rate rates at that pace.
2: Weekly Unemployment Claims. They look decent so far. The level is still below 300k. Claims have risen a little bit, but that’s from record-low levels in the Fall of 2022.
3: The Manufacturing PMI. It currently stands at 47.1 for the month of April. Below 50 indicates contraction, but for a recession, we’d need to see a more significant dip below 50.
So, out of the 3 indicators I regularly follow, one is bad (finance/yield curve), one is good (labor market), and one is only so-so (manufacturing). Overall, that’s not screaming recession, but it’s not consistent with a completely healthy growth path either. It definitely signals below-average momentum for the economy. With a shaky economy like that, it makes it all the more important for the Fed not to overreact.
Conclusion
To conclude, lingering inflation is mostly due to price stickiness in rental inflation and the rockets and feathers issue, as outlined above. I cross my fingers that both effects will eventually run their course. We’ll arrive at more palatable inflation rates over time, certainly by 2024. The importance of the current low unemployment rate is vastly exaggerated. So, I’m more worried about what the Fed might do about inflation than inflation itself.
And that’s it for today! I hope you enjoyed my ramblings here and found some information that you wouldn’t find elsewhere on the web.
Lots of great insight in there! As you mentioned, Fed should have started earlier, but ok job considering (so far). If inflation was transitory, their rate increases could have been transitory too.
My take is we have too much debt in the system and there are four options:
– Cut spending
– Raise revenue/income
– Default
– Inflation
Getting debt to GDP ratio back down will rely primarily (>85%) on inflation with done via stealth cuts to spending and stealth revenue gains. The last two done by not adjusting tax brackets accurately, tweaks to SS formulas, or annual COLA on benefits below inflation.
The only one I see happening is the last one, since there are too many interests to get much agreement on the others. I predict inflation bounces between 4-10% for a decade as revenue and spending keep going up.
Going to be a slow steal from bond holders and average citizen.
Solution: Hold assets, have a fixed mortgage under 3%, and don’t own fixed-rate debt.
Thanks! The scary thing will be that we will have a lot of debt and inflation heads back to the 2-2.5% range. So, cutting spending might be back on the table.
The Fed will not be happy with 4-10% inflation! 🙂
Re the Fed trying to “raise” unemployment to slow the economy and thus decrease inflation, I’m concerned that no one seems to be talking about how we’ve lost a LOT of working-age adults recently (and we’ll keep losing them for the foreseeable future) due to 1) people suffering from long covid so much they can’t work, 2) baby boomers retiring en masse, and 3) decreased legal & illegal immigration since 2016 thanks to the Former Guy. Like you I’m worried this means the Fed will keep boosting interest rates when it really shouldn’t.
Yes, that’s a great point I hadn’t considered yet. Not a good idea to manufacture a higher UER when all those issues are still going on!
Or that fact that the Fed is controlling labor market yet not corporate greed. It is estimated that 30%+ of inflationary causes are because of the coporate money grab post covid, yet no one is developing or implementing policies to control that.
The Fed is not interested in distributional issues like that.
Extremely insightful as usual, thank you! The rockets and feathers analogy made a ton of sense. Leave it to untethered businesses to take advantage… every time.
Yeah, that analogy is well-known in econ but hasn’t gained much popularity in the general public. I try to change that! 🙂
understood. anything that “we” can do to move the needle? cause this is killing my ability to retire.
With valuations a bit more palatable because the market is down, plus higher yields on nominal assets, plus inflation coming down, it may be a good time to retire again. See SWR Series Parts 51 and 54.
reading now!! 🙂
Regarding the first chart, I’ve always believed you can only compare against “average” inflation over really long time frames, at least a decade anyway. If you plot back ten years you would cover a number of years with record low inflation, making the 10yr average look much more reasonable, and the recent spike could even be considered a mean reversion.
Good point. I did that. The 2% inflation trend came from the 2% inflation average between 2000 and 2019. I didn’t plot the entire chart from 2000 because I wanted to focus on the recent 5 years. But we can all agree that the trend broke in 2020. This isn’t mean reversion.
Great post! I learned a few things, as usual.
One thought: A larger share of layoffs are impacting professionals & higher earners (in the tech industry, e.g.).
One question: Do you think the relatively low weekly unemployment claim number (300K) could be impacted by higher earners delaying their claims till their severance packages run out?
The layoffs in the tech industry have been going on for a long time. There should be plenty of “customer” in the claims numbers already.
Another great post! I also liked the one on recessions that you link to…
[If you’re bothered by pedantry, please stop reading now.]
… because that post never calls the NBER “official”. Is the NBER really the official arbiter of recessions? They could very well be the best and most widely referenced arbiter of recessions but that doesn’t make them official. I can’t find any official act by a government official that made them official. They are widely referred to as official (even the CEA https://www.whitehouse.gov/cea/written-materials/2022/07/21/how-do-economists-determine-whether-the-economy-is-in-a-recession/) but unless that post was the official act then I think they’re just the unofficial arbiters. Even the NBER FAQ (https://www.nber.org/research/business-cycle-dating/business-cycle-dating-procedure-frequently-asked-questions) only calls themselves “quasi-official”.
The NBER is the official arbiter of recessions in the US. Whether you want to call it official or quasi-official, that’s all semantics. In the absence of another more respectable body calling the shots, the quasi-official is the official.
Re “rockets and feathers” I rather like the (I think newer) term of greedflation.
Greed is a strong word. I would call it Bertrand equilibrium with imperfect information, where the optimal and rational action of sellers is to slowly walk down the price. It’s mathematically the right thin to do for sellers.
Yes, it is strong. But is it wrong?
For example, why not apply the same logic on the way up too?
Greed certainly includes profit maximization. But greed also involves profit maximization with potentially unethical or even illegal means. So, that’s why I object to “greed” and simply go with economically optimal and rational behavior.
And on the way up, again, you optimally set your prices according to input price pressures. So, the same logic of Bertrand equilibrium works both ways. Only on the way up you go faster and on the way down you go slower. All perfectly consistent with basic economics.
It’s so interesting reading your stuff. I am curious if you have any thoughts regarding Scott Sumner’s work ( can be found on Econlog or his blog Money Illusion). In essence, Dr. Sumner argues that the fed raising or lower interests rates does not do what we think it does (at least in the long run, obviously there is some short term impact). In other words, raising interest rates is NOT tightening and lowering interest is NOT expanding. Furthermore, he is a big proponent of NGDP targeting, a topic I am still trying to wrap my head around. You should give his Econtalk episodes a listen. I’d be curious to know your thoughts since you’re both “freshwater” economists (he is a grad of UChicago)!
I don’t think that today’s monetary policy should be the last iteration. The Taylor Rule is almost as troubling as the NAIRU nonsense. So, yeah, I’m open to considering other ideas. I can’t really comment on all of Dr. Sumner’s ideas until I’ve listened and read more, though. For example, the so called “Modern Monetary Theory” (MMT) is a new concept, too, but it’s totally insane and stupid. So, just because the old stuff has some problems doesn’t mean we should throw out everything we’ve been doing so far. But Sumner’s work might have a better chance than MMT, for sure!
Completely agree with the whole MMT issue. Sadly, it seems to not want to go away. To keep going on the claim that the fed’s ability to tighten/expand is exaggerated, Aswath Damodaran has some posts detailing why he feels the fed does not control interests and that really all we are seeing is a reflection of the “perception” that the fed can control rates. As a finance/econ guy, what do you think? He makes a compelling argument and the data seems to support his claim. Furthermore, if it is the case, then perhaps all this attention to the FOMC meetings/conferences is just noise?
https://aswathdamodaran.blogspot.com/2013/06/the-fed-and-interest-rates-lessons-from.html
https://aswathdamodaran.blogspot.com/2018/03/interest-rates-and-stock-prices-its.html
As always, really appreciate all your work and transparency. By far the best blog out there. Keep up the stimulating and informative work.
Cheers
I’m hopeful that MMT has taken a beating recently and most people will lose faith in it. The idea that we can print money and spend like crazy without consequences had to face reality eventually.
I know Damodaran. He’s the “valuation God.” I highly appreciate his insights in that area.
He should probably stay in his lane, though. The Fed controls short-term rates. Long-term rates indirectly through short-term and directly through bond transactions.
His argument is silly. One little naïve regression doesn’t prove anything. Especially if you regress rate changes on Fed moves. Part of the interest move happens before the fed hike because Fed moves are anticipated 90+% of the time.
I thought MMT suggests that gov’t spending should not be arbitrarily constrained as long as inflation doesn’t show up. Government should be willing to take up the slack in the economy by deficit spending. Obviously with the trillions poured into the economy since 2020, inflation did show up once the economic slowdown subsided. I suspect that with a couple decades of low inflation despite increasing debt, some wondered where the limit to spending was. We obviously hit it the last few years.
Good point. Though, I haven’t heard from any MMT fans breaking down the doors of Biden/Schumer/McCarthy demanding they spend less now, because we finally hit the wall.
I remember in 2020 when Mark Cuban who usually has pretty rational well thought out business/financial ideas, was jumping on the MMT train and calling for the government to give out $1k/mo and to take away any unspent money. What was he and the other MMT fans thinking that they would spend their money on during a pandemic other than bidding up the price of homes, cars, and meme stocks while stuck at home.
Yeah, that’s a good example for why we should resist the temptation of listening to economic advice from business leaders. They have no clue. Just like econ experts have no clue about running businesses. The stimulus $$$, plus student loan interest holiday poured so much fuel on the fire. It’s time this insanity comes to an end!
It looks to me like the Fed is using the Taylor Rule to guide policy. The TR in a nutshell says to reduce inflation, increase the Federal Funds Rate (FFR) to a point above inflation, and to stimulate inflation, decrease the FFR to a point below inflation. James Bullard was giving presentations last fall predicting a 5%-7% terminal FFR based on the output of Taylor Rule equations, at a time when markets were thinking we’d have a sub-5% FFR.
A huge gap between inflation and the FFR opened up between 2021 and earlier this year. However, the 12-month rate of inflation is now falling faster than the FOMC’s rate hikes are going up. We’re now at a point where the FFR, at 5.25%, is higher than CPI (4.9%), PCE (4.2%), Core PCE (4.6%), and the PPI (2.3%), but lower than Core CPI (5.5%). Some of those numbers are months old by now, so we may already have a FFR greater than any reasonable definition of inflation. The next CPI release is on the 26th.
The question is whether to firmly drive the stake in the heart of inflation by hiking the FFR far above inflation, or to take a break and let inflation fall below the FFR all by itself?
Obviously, a robotic “inflation remains too high, so hike rates monthly” approach would overshoot, leading to something like a 6.5% FFR by December. By that time, inflation on its current 10-mo average trajectory of -0.4% per month will have fallen to near 3% so that would be overkill. On the other hand, inflation might bounce back if the Fed pauses now, amid overheating in the employment and housing areas, each of which filters down to cycles of very sticky wage increases.
I think the Feds talk a lot about employment because they want to show they are balancing their 2-part mandate of conflicting goals, and to defend themselves against accusations that rate hikes are damaging the economy. JPow has been harping since late last year about the gap between job openings versus unemployed people, and noted today that the ratio is something like 2:1. So, the thinking goes, tighter policy can cut into those excess jobs for a while before we reach the point where there are more job seekers than jobs. JPow has shared this thought process with us directly.
In this way the Fed can defend their application of the TR, which is a bit too cold a calculation for political palatability. A lot of people are about to get mad over losing their jobs and businesses.
Even using a very dovish TR, i.e., FFR = 0.5% + CPI + 0.5*(CPI-2% target) +0.5*output gap, we’re still getting a FFR target way above the current rate. And this is with a 0.5% real rate target, instead of the old, customary 2% target. Using a -1% output gap and 4.9% CPI, this TR generates a FFR target of 6.35%. You’d already have to factor in the next two monthly CPI declines to justify today’s FFR. But maybe we should do so because of the policy lags. It all boils down to the same issues I brought up here. There are some components of inflation with long lags (housing, especially), so using the traditional Taylor Rule is bound to overshoot the interest rate.
Good points ERN, and thanks for filling in some numbers on the TR equation. Throw in the likely annualized CPI number for June or July (-0.4% each month) and the TR will spit out a different answer, closer to 5.25%-5.75%. FOMC members are probably (at least I would hope) running their own TR calculations and watching the recommendation drop month after month.
I’m reading between the lines of Fed commentary and seeing a lot of committee members thinking about an every-other-month cadence until inflation falls far enough below the FFR that overshooting isn’t necessary to shock it down. The airplane must level its descent before touching down on the runway. This might be a great illustration of why we put a committee of trend-sensitive humans in charge, instead of automatically setting the FFR based on a model.
Real positive rates can be had through hiking the FFR or simply waiting, and with all the recession / banking crisis / real estate crisis signals swirling there is a strong case for waiting and letting QT continue doing its money supply destruction work. A rate hike EVERY single FOMC meeting is a rare emergency response, and a case could be made that we are already out of the emergency zone. About 9-10 months ago, JPow identified positive real rates as a precondition to pause the rate hiking campaign, and now here we are.
I would vote for a pause if I was on the FOMC. A recession is definitely on the way, so in 12 months we’ll be asking ourselves how many rate CUTS will occur. An overshoot now will only add pressure to make deep cuts and put us on the 1970’s yoyo pattern.
Good point. This would mean we wait until the July FOMC meeting. By then, we’d have 2 more CPI and 2 PCE releases. I hope that inflation falls far enough below the 5-5.25% rate.
As goods inflation and housing prices stabilize, isn’t the FED mostly concerned with the remaining core service ex shelter inflation – which is flat lining above target? This inflation is heavily influenced by wages, which is also trending high relative to productivity gains.
If this understanding is correct, high unfilled job opening rates could be a driver for sticky inflation.
They should be worried about overall inflation (maybe overall core). If they want to look at services inflation note that it tends to be higher on average (80-100bos p.a.). There’s no way you can bring that down to 2%!
And again, employment is a nice intuitive driver of inflation. But empirically it hasn’t been.
Yup. And it’s 3-month running avg has been hovering around 4% since December, so it’s a good 1 pp too high and sticky.
Unfortunately their only tools to achieve their mandate and the fed fund rate and QE/QT.
Unemployment rate hasn’t well correlated, but what about JOLTS data?
I haven’t run that regression with JOLTS. Maybe someone can convince me that JOLTS data work better?!
You present a nice overview. Much better than the main-stream biased media.
Let me summarize it, as I see it…The Fed did damage by artificially keeping rates near 0% for too long (along with other western central banks). Then, recently, the majority of elected officials spent too much taxpayer dollars (with some consideration to several black swan events; pandemic, Ukraine, some bank officials who don’t follow Risk Mgmt course 101, etc.) and shot up the debt. The markets are being propped up by just a few corporations, such as Apple and Microsoft who are about 15% of market between the two of them, with many smaller companies below their market peaks. My crystal ball indicates a recession with the S&P500 to dip to around 3200-3400 before expansion of the economy again.
Recall that the Fed tried to raise rates off of zero with a long, slow string of rate hikes between 12/2015 and December 2018. After hitting a 2.5% upper bound in December 2018, the stock market had its worst December since 1931, the 10y/2y yield curve came within a hair of inverting, CPI went up to 2.8% amid Trump’s Chinese tariffs, and the Fed quickly cut rates to a 1.75% upper bound, where it stayed until the pandemic.
A counterintuitive argument could have been made that the Fed should have never raised rates in that timeframe, and that because they raised rates, we were due for a recession in 2020 anyway, even if the pandemic hadn’t happened.
Quite intriguingly, the yield curve did invert briefly before the pandemic. So, some folks argued that there would have been a recession either way.
Also, the Fed was way too aggressive in Dec 2018. Shocking the market in mid-December and then send everybody off into the Christmas lull. Really bad decision.
Hah, good summary!
I’m still hopeful that inflation drops fast enough to bring the hardcore FOMC members to their senses. And yes, a recession would drag down the S&P again, likely to below the lows we’ve seen last summer.
Another great post, Big Ern.
Related to all you wrote above, I’m interested in your thoughts on a theory (widely repeated on the internet) that our government has a covert agenda to just let inflation run – because it would inflate away our debt….
But as a counter argument to this, Bernanke was once quoted, as saying the below:
{Fed chairman Ben Bernanke sat before the Joint Economic Committee, which asked him point blank about inflating away debt. His answer gets to the heart of the matter: “Given the structure of our debt, [inflation] wouldn’t even help reduce the debt … given that so many of our obligations are indexed.”}
So, is it true that we really do have to pay back over $31T in debt in “real” dollars?
I’ve heard so many politicians suggest/shrug that we don’t really have to pay it back, as defense for their massive spending….
I don’t buy it, but wondering if they actually know something that I don’t….?
Said differently, is it a good time to buy long-term TIPS?
I can’t vouch for the accurqacy of that quote and whether it might have been taken out of context.
Let’s get one thing clear: the overwhelming majority of our debt is in plain old nominal Treasury bonds.
The overwhelming majority of our future obligations (federal employee pensions, Social Security, etc.) are inflation-indexed.
So, the fiscal authority may feel the temptation to inflate away the debt but that’s only a very short-sighted solution. Also, once nominal bonds mature they have to be reissued at the higher rate if there’s rampant inflation. So even the nominal debt is not that easily solved with inflation.
So, I agree with Bernanke, the old tale that the fiscal authority wants high inflation is a bit exaggerated.
If you find the current TIPS yields attractive (1.47% for 10Y, 1.71% for 20Y and 1.67% for 30Y), yeah, go ahead. I still cross my fingers that inflation will subside soon once housing inflation starts cooling.
Hi ERN!
Many of the TIPS have principal levels 10-20% above par. while some are very close to par.
Would you advise cherry picking TIPS that are close to par to protect against deflation shock tail risk and inflation risk in one instrument?
My interpretation is TIPS only protect against deflation below the original issued principal value, but maybe I’m wrong.
TIPS above par have some additional risk because only the par value is protected against inflation. I’m not an expert in TIPS trading, but I’d think that an efficient market would give you a little bit of an extra risk premium when trading in the secondary market, though. So maybe cherry-picking isn’t really necessary. But to be sure, I’d probably stick with the close-to-par TIPS.
Thanks ERN!
Excellent post.
Thanks!
Interesting stuff. I’ll accept your statement that NAIRU has no predictive power but are you going as far to say that unemployment rate has no implications for inflation? That would seem to imply that the normal relationships between supply/demand balance and pricing power do not apply in labour markets. I struggle to see why that would be so. Do you have a theory? BTW I appreciate that no one measure if labour market tightness tells the full picture and it could be that labour participation rates, job vacancies, working age population demographic trends, etc, etc need to be integrated into a full view of labour market tightness. But given wages are the biggest element of a developed economy cost base it is difficult to believe that the pricing power of labour is irrelevant to inflation.
Macro shocks can take the form of demand or supply shocks. Positive demand shocks raise inflation and and lower the UER. But with positive supply shocks you lower the UER and inflation. This explains why the relationship between UER and CPI is so spurious and unreliable.
Great thing! Most of the studies appears to concentrate on later-life benefits like social security. Certain FIRE members start a pension immediately after retiring from their military career. I will likely retire from the military at 45 with a US government-backed inflation-adjusted pension. I wonder how it would influence my other savings’ SWR. Given the pension guarantee, I may tolerate a higher SWR on my other funds. I anticipate my pension to pay 40% of my yearly costs. Are there additional articles or discussions about this? Thanks!
See my replies to the other similar comments).