Stephen Miller
The tone in financial markets through July and the first half of August suggested that markets were growing increasingly confident that the world’s central banks had the inflation beast (almost) tamed, and that any recession would accordingly be relatively shallow and short-lived. Bond yields fell sharply from their mid-June highs and equity markets staged an impressive comeback, while the USD appeared to lose a little of its lustre – in short, “goldilocks” was back.
To my mind the markets adopted a narrative that owed something to the soporifics that accompanied the record-breaking (northern) summer heat. Minack Advisors, in a typically sage note, thought markets engaged in an “immaculate disinflation fantasy”.
It was not a narrative that was ever even adopted by the Fed, even after the better-than-expected July consumer price index (CPI) inflation outcomes. Admittedly, the July CPI result likely represents a peak in the recent inflation episode. However, for the Fed the key issue is not whether inflation has peaked but how quickly it gets back to something below 3 per cent.
Various Fed spokespeople voiced scepticism that the market pricing of the trajectory of the Fed’s policy (federal funds) rate was consistent with a smooth return to circa 3 per cent inflation by mid-2024.
At the forthcoming Kansas City Jackson Hole Symposium, Fed Chair Powell will likely reinforce the central bank’s hawkish message.
Even if Chair Powell signals that policy increments may be lower (50 bps as opposed to 75 bps) and even if he expresses some sensitivity to risk that the Fed could tighten the stance of policy by more than necessary to restore price stability, the overarching message will be that the primary focus will be on vanquishing inflation.
Such an eventuality may cause markets to apply a more critical eye to the “goldilocks” scenario. Perhaps in anticipation, the past week has seen bond yields climb, equities struggle, and the USD regain its lustre.
And there may be more than that to come. Market pricing currently has the Fed’s policy rate peaking around 3.70 per cent early in 2023 before declining back toward 3.50 per cent and below thereafter. That would mean that markets are anticipating that the “trailing” real policy rate will struggle to get above zero over a two year horizon. That hardly looks “restrictive”! This is not to say that such an outcome is implausible but were it to occur it would mean that the cyclical peak in the real policy rate would be extraordinarily low, both compared to history and against the background of a multi-decade high in inflation.
Such scepticism of the veracity of market pricing is reinforced by just how stubborn broad-based measures of inflation have been.
Measures of the ‘underlying’ inflation pulse continue to show extraordinary momentum and no retreat from the historically high levels recorded in June. On a three-month annualised basis, the Cleveland Fed measure of trimmed-mean inflation continue to run at 8.4 per cent.
Such readings suggest that inflation is more than just a few outsized price increases in selected commodities or ongoing supply chain blockages. Rather, that sort of inflation pulse is indicative of an inflation inertia (last seen in the late ‘70s / early ‘80s) that may yet prove a lot more difficult to arrest than markets are currently contemplating.
In that sense while the July CPI report might ease the pressure on the Fed (ever so slightly), but it is a long way from taking it off entirely.
Current pricing for the Fed is therefore located at the benign end of the risk continuum.
Even more so if, as seems to be the case, inflation is “sticky” and declines only grudgingly toward 3 per cent.
In this context the real and nominal policy rate may need to go significantly higher in the current cycle probably requiring a “4 handle” in nominal terms.
A case of summer soporifics turning to the summertime blues.
Will weaker activity readings cause the Fed to significantly ease the brakes?
The weakness exhibited in some recent activity indicators is by no means uniform. Housing and selected PMIs have shown weakness (the former after a pandemic and policy induced boom). Labour market indicators have held up reasonably well, retail activity indicators have been satisfactory and the recent corporate earnings reports not too bad. The reality is that current weakness in activity was ‘baked in the cake’ in 2021 as all central banks, including the Fed, embraced for way too long the “transitory” narrative around inflation. By failing to appreciate the magnitude, momentum and persistence in inflation and leaving monetary settings at historically high levels of accommodation, central banks, including the Fed, now find themselves in the realm of “least bad” or “second best” solutions (some central banks – the Bank of England (BoE) and the European Central Bank (ECB) – look to have missed even that opportunity). The Fed, along with certain other central banks (the Bank of Canada, the Reserve Bank of New Zealand (RBNZ), and latterly the Reserve Bank of Australia (RBA)) appear to have learned (admittedly late in the piece) the lessons from ‘70s style inflation: viz, that any delay in implementing a coherent and firm response to an inflation threat only heightens the risks of more substantial macroeconomic dislocation down the track. That is why the Fed will be keen to continue to move expeditiously to neutral or beyond to restrictive settings, even in the face of weaker activity readings. Indeed, weaker activity is embodied in the current Fed forecasts.
By Stephen Miller, investment strategist
