Viewpoints: 2022

Inflation cycles are complex, with many interconnected parts. Price changes flow unevenly through the distribution and production channels, lifting final product prices. For example, consumer price inflation doubled from 4.2% to 8.3% in the past year. Yet, that surge is directly linked to even more significant price increases for thousands of items in various processing stages. Indeed, producer prices for crude goods rose 48% over the same period, intermediate materials by 22%, and finished producer products by 16%.

Consequently, taming or reversing the inflation cycle is not as simply slowing or ending the price increases for consumer goods and services. Instead, it requires a broad price reversal across various products and services, impacting production, distribution, and retailing businesses. And that "unwind" process is destabilizing and uneven, resulting in liquidity and cash flow squeezes and profit and income declines.

The Fed's immediate goal is to bring consumer price inflation back to a 2% rate. Although there are many paths to a 2% inflation rate, the most common, based on recent experience, is a sharp slowing in consumer commodities (goods) prices, which accounts for 40% of the overall CPI.

CPI commodities (goods) prices have increased by 13% in the past year. Not surprising, these retail prices are nearly perfectly correlated (86%) with producer prices for intermediate materials, which have increased by 22% over the same period. Moreover, the correlation is robust, even removing the volatility from food and energy, with core consumer commodities rising 9.7% in the past year compared to a near 17% increase in core intermediate prices.

A few episodes have occurred, none recently, in which intermediate materials and consumer commodities prices dropped from double-digit increases to near zero. Fueled by restrictive monetary, prices of producer materials and consumer goods fell hard and fast in the mid-70s and early 80s. Both periods, heavily influenced by supply-side shocks, resulted in economic downturns that ran for sixteen months, nearly a half year longer than the average recession of the post-war period.

So it is not surprising to hear Fed policymakers say, "it will be challenging, not easy," to bring inflation back to 2% from 8% without triggering a recession. That's because it's never been done. And very easy to see why.

For a broad set of industries and businesses, equaling nearly half of the economy, there would be a "flash" crash in prices. On average, price increases would drop from annual gains of 10% to 20% in a year to zero. Yet, given the unevenness of price cycles, many firms would even experience price declines. Sharp price reversals would trigger an abrupt drop in revenues and profits, forcing cutbacks in output and labor.

The unwinding of price cycles creates many losers because the Fed is negatively impacting the flow of commerce and finance through its restrictive policy moves. So far, the losers are in finance-- bonds, equities, and crypto, along with increased volatility. However, investors should expect much more since the Fed tightening cycle, which has just begun, needs to crack the many links of the inflation cycle.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

Some have used peak inflation to create the impression that the worse of inflation news is in the rear and that the Fed has less tightening to do than what many expect. Yet, peak inflation says a lot about what the Fed has to do, which should worry the Fed and scare investors.

In three out of the last four decades, the US experienced a cyclical rise in inflation (4% and above) that compelled policymakers to raise official rates in response. It didn't matter if the inflation cycles were broad (the early and late 1980s) or narrow (oil spike in the mid-2000s). But policymakers had to raise official rates above peak inflation on each occasion to squash the price cycle.

No one is thinking the unthinkable that the Fed has to raise rates above the 8.5% increase in consumer prices over the past year. Yet, past experiences provide painful lessons on the level of official rates required to reverse inflation cycles.

Each inflation cycle has common and unique factors. However, many, including Fed officials, have argued that the current inflation cycle has more than a few items lifting prices temporarily. The Bureau of Labor Statistics (BLS) produces a special aggregate series that removes some things people have cited, so it helps remove some of the noise.

For example, BLS published a series of CPI less food, energy, shelter, and used car and truck prices. This series removes the recent temporary spikes in food and energy prices linked to the Russian invasion of Ukraine. It also removes the massive spike in used vehicle prices associated with supply bottlenecks owing to the pandemic. Yet, this dumbed-down price series still shows a 5.8% in the past year, matching the highest rate recorded in 40 years.

So even if this is the inflation rate the Fed needs to target to reverse the inflation cycle, it still calls for a fed funds rate of 6% or more than twice the peak rate shown in policymakers' official rate projections made in March.

Given how tight the labor markets are nowadays and everything else being equal, it would probably take a 6% fed funds rate to impact consumer demand and dampen inflation by creating more unemployment. At the end of March, there were a record 11.5 million job openings against a backdrop of 6 million unemployed. Never before has the Fed faced a significant inflation cycle with labor markets this tight.

Yet, I would bet that long before the fed funds rate gets close to 6%, something else would break to stop the Fed. Things that stopped the Fed in the past were an abrupt and sharp drop in the financial markets or a cessation in the flow of credit that could lead to economic and financial instability.

Given the current market environment, none of those conditions are present, so the risk, for now, is that Fed tightening course could look a lot like those of the past until something else breaks. Investors forewarned.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

Treasury Inflation-Protected Securities (TIPS), which are marketable securities, compensate the investor for inflation by marking up/down the principal of the outstanding security every six months by the six-month CPI inflation/deflation rate. The fixed coupon rate on the originally-issued TIPS is applied to the adjusted principal every six months. If you want to know the full skinny on TIPS, Google treasurydirect.gov. But what I want to discuss is the negative yield on TIPS starting at or about the time of Covid-induced March-April 2020 recession (the red and blue lines in the chart below.) Why have TIPS yields continued to remain negative since the Covid recession? I think the answer lies in the green bars in the chart. Each green bar represents the 24-month dollar change in Fed holdings of TIPS as a percent of the 24-month dollar change in total outstanding TIPS. In the 24 months ended July 2020, the dollar change in Fed holdings of TIPS was greater than the dollar change in total TIPS outstanding, as represented by the green bar being over 100%. The green bars have continued to be above 100% through February 2022. In recent months, the Fed has been “tapering” its purchases of securities, including TIPS. But in the 24 months ended July 2020 through the 24 months ended February 2022, the Fed has been buying all of the TIPS being issued by the Treasury and then some. With a price insensitive purchaser like the Fed buying more than 100% of the new issues of TIPS is it any wonder that the yields on TIPS have been negative? Starting any day now, the Fed is going to turn into a net seller of TIPS. TIPS yields already have moved up close to zero. When the Fed begins to sell them, TIPS yields almost assuredly will rise above zero and rise rapidly. Wonder what will happen to the yield on mortgaged-backed securities when the Fed starts to unload these too?

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

"Core" this and that is all the rage these days. Soon to be retiring Chicago Fed President Charlie Evans is now talking about a supercore CPI. What is that? A CPI that excludes all items that have increased in price? But I digress. The headline of the media reports of the Bureau of Economic Analysis (BEA) release of its first guesstimate of the annualized percent change in real GDP for Q1:2022 was "economy contracts by 1.4%". Oh my. Call off Fed interest rate hikes because the economy has one foot in the recession grave? I referred to this advance estimate of GDP as a guesstimate because the BEA does not yet have complete first-quarter data for net exports, inventories and residential investment. So, cool your jets. I will argue that the part of the economy that the Fed has the most influence on, real private domestic sales excluding inventories (or real private domestic final sales), apparently picked up in Q1:2022.

The advance estimate of first-quarter real GDP was held back primarily by real net exports and the change in real inventories for which, again, March data still have not been released. Real net exports held back first-quarter real GDP by 3.20 percentage points; the real change in private inventories by 0.84 percentage points. And for good measure, real government, combined federal, state and local, retarded first-quarter real GDP by 0.48 percentage points. With defense expenditures likely to be increasing and infrastructure spending gearing up, how much longer will government expenditures on goods and services be a drag on real GDP?

But if we look at real private expenditures for goods and services, excluding inventories, the spending most influenced by monetary policy, we find a different picture. This is just a fancy name for combined real personal consumption expenditures, real private fixed-investment expenditures, including business and residential investment. As shown in Chart 1, this measure of real aggregate spending grew at an annualized pace of 3.66% in the first quarter, up from the annualized pace of 2.57% in Q4:2021. The 2017 through 2019 median quarter-to-quarter annualized growth in real private domestic final sales has been 2.72 % (the thin blue horizontal line in the chart). So real private final demand grew in Q1:2022 faster than it grew during those pre-Covid glorious years when the US economy was great again.

Chart 1

Central bankers would be the first to admit that domestic monetary policy is a blunt tool for steering economic growth and inflation. Alan Greenspan famously observed that setting policy can be like driving a car while looking in the rear-view mirror. He noted too that arriving sufficiently early “in order to take to away the punch bowl just as the party gets going” is often equally, if not more, challenging.

To extend these metaphors a little further a big problem at present concerns the image in that rear view which is shrouded in fog. In the meantime there is much uncertainty about how many guests have arrived at the party. Even more debatable is whether the punch bowl that's been provided actually contains any punch!

To elaborate on this let's look at a few charts. The first of these suggest the world economy's current inflation tensions are mainly rooted in global supply-side factors. Specifically figures 1 and 2 below show that higher commodity prices in recent months have been mostly responsible for the burst of positive global inflation surprises. That's incidentally as true in the US as it is in, say, Australia. Insofar as higher commodity prices are rooted in global supply-chain bottlenecks that have been choked by both the COVID pandemic and the Russia/Ukraine crisis combatting these inflation tensions via tighter domestic monetary policy will be challenging to say the least.

Figure 1: Inflation surprises in the G10 have been heavily driven by moves in commodity prices

The headlines remain full of negative news about the conflict in Ukraine, a cost-of-living crisis and lingering COVID-related issues not least in China. These factors are derailing consumer and business confidence on the one hand but aggravating inflation tensions on the other. And central banks are accordingly facing an acute dilemma with attendant risks of a policy error extremely high.

One feature of the global economic scene, however, that is arguably receiving less attention than it should concerns the growing desire of companies to invest in new technology and the positive impact from this on productivity growth. As we discuss below the latest dataflow suggest global demand for technology products has been strong, that capex intentions remain firm, and that trends toward technology innovation - and productivity growth - have exhibited ongoing improvements.

On the demand front we can see the evidence for this from surging orders from US companies for capital goods (see figure 1 below) and from surging exports of trade and technology bellwethers such as South Korea and Taiwan (figure 2).

Figure 1: US capex orders continue to strengthen

Although a few presumably temporary factors have lifted reported inflation well above expectations, it is also true that some elements made it look less troublesome. So what is the truth about the current inflation cycle?

The Bureau of Labor Statistics (BLS) provides special aggregate price series that remove the noise, or an underestimate from these factors. For example, BLS published a series of CPI less food, energy, shelter, and used car and truck prices. This series removes the recent temporary spikes in food and energy prices linked to the Russian invasion of Ukraine. It also removes the massive spike in used vehicle prices associated with supply bottlenecks owing to the pandemic. On the flip side, it removes the controversial shelter component that no longer captures house price inflation.

In April, BLS reported this price series increased by 0.6% month-on-month, matching the gain in March and twice that of the 0.3% gain in the so-called core inflation series. This price series has increased by 5.8% in the past year, matching the highest rate recorded in the prior 40 years.

The surge in this price series also represents a significant milestone. It breaks four decades of lower peak-to-peak consumer inflation rates in the business cycle. Business cycles have shown that there is a cycle in prices. Yet, up until the Volcker era, the peak-to-peak was progressively higher. And after the Volcker era, the peak-to-peak inflation rate has been progressively lower or stable.

Also, the surge in this price series shows that the current inflation cycle is not a "blip." On the contrary, it is widespread and more embedded in the decisions and expectations of consumers and businesses.

It is unclear if the current generation of policymakers is aware of the price cycles in the business cycle or how pipeline pressures feed into product prices. For example, the producer price report showed significant increases at all three processing stages in April. It's unlikely that monetary policy can break these price increases with modest increases in policy rates.

Companies need materials and supplies to protect production schedules. Notably, the April survey of manufacturers from the Institute for Supply Management showed that customer inventories are near record lows. As a result, it would take exceptionally high-interest rates to force companies to pull back on the inventory investment needed to sustain production.

Although policymakers have yet to list easy money as one of the causes of the current inflation cycle, it plans to make money much more costly to break the cycle. Yet, how far are policymakers willing to take official rates to reverse the price cycle?

The current official rate projections of policymakers show a peak fed funds rate of 2.8% in 2023, less than half the inflation rate, excluding the unique factors. Never has an inflation cycle been reversed or broken without policy rates moving above the reported inflation rate.

Investors will soon need to confront whether the higher cyclical peak inflation rate is a one-time occurrence or a sustained shift to higher rates? I bet its the latter because the current generation of policymakers is unaware of how price cycles start and end.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.