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What Happens Next?
As far back as I can remember, I’ve been fascinated with the fetish that investors have about forecasts and predictions. When I was a strategist, clients wrangled me for a simple statement of where the market was going to go. I had my opinions, to be sure, but by the time I was a senior strategist I also knew that even good forecasters are wrong a lot. Forecasting, ironically, is not a job for people who care very much about being right. Because if they do care about being right, even good forecasters are depressed a lot.
So in my mind, a useful strategist was not one who gave all the right answers. Those don’t exist. A useful strategist was one who asked the right questions. Investing isn’t about being right; if it was, there would be no need to diversify. Just put everything in the one right investment. No, investing is about probabilities, and about maximizing the expected outcome even though that is almost never the best outcome given the particular path of events that actually transpires. Knowing the future is still the best way to make a million dollars.
A valuable strategist/forecaster, then, is not the one who can tell you what they think the actual future will be. The most valuable strategists have two strong skills. First, they excel at if-then statements. “If there is conflict in the Ukraine, then grain prices will soar.” Second, they are very good at estimating reasonable probabilities of different possibilities, so you can figure out the best average outcome of the probability-weighted if-then statements.
However, there aren’t a lot of great strategists, because those same characteristics are exactly what you need to be a good trader. I can’t remember if it was Richard Dennis or Paul Tudor Jones or some other legend who said it, but a good trader says “I don’t know what the market is going to do, but I know what I am going to do when the market does what it is going to do.”
As an investment manager/trader, that’s the way I approach investing. I don’t often engage in a post-mortem analysis about why I was wrong about how a particular chain of events played out, but I often post-mortem about whether the chain of events caused the market outcomes I expected, or not, and why.
All that being said, people keep asking me what I think happens next, so here is my guess at how the year will unfold. Feel free to disagree. I don’t really care if this is what happens, since my job is really to be prepared no matter what happens. But, you asked.
- I suspect the conflict in Ukraine will continue for quite a while. I also think there’s a reasonable chance that other countries will take advantage of our distraction to be adventurous on other fronts. April is a key month, and I think Russia might be waiting for this other front to open up before pushing harder in Ukraine.
- However, except inasmuch as the geopolitical uncertainty plays into the general deglobalization of trade, I don’t think about particular outcomes of Russian or Chinese adventurism. I don’t think the long-term inflation trajectory has a lot to do with who is invading who. In the short term it matters, but in the long run it means certain goods will have different relative prices compared to the market basket compared to what they have now – not that incremental inflation of those items, the rate of change of those relative prices, will continue. For example, cutting off the supply of Russian natural gas to Europe would permanently raise the relative price of nat gas in Europe, but after prices adjusted it wouldn’t permanently cause a higher level of inflation of natural gas.
- March’s CPI print, released on April 12th, will probably be the high print for the cycle for headline inflation, at around 8.5%. Core inflation will also peak at the same time, around 6.50%. This is mainly due to tough comps, though. Monthly prints will still be running at a 4-5% rate, or higher, for at least the balance of the year, and we will end the year with core around 4.5%-5%.
- The Fed is going to tighten again. I doubt they go 50bps at this next meeting unless the market is expressing desire for that outcome. The market sometimes fights the Fed, but the Fed these days doesn’t fight the market. The FOMC might even start reducing the mammoth balance sheet through partial runoff, but I suspect they will pocket-veto that and not do anything for a couple more months.
- Interest rates are going to go up, further. Real interest rates are going to rise – actually, our model says that more of the rise in nominal interest rates so far should have been real rates, so TIPS are actually marginally expensive (which is very rare). Long-term inflation expectations are also going to continue to rise, until at least 3.5%…something in line with the reality of where equilibrium inflation really is now, with an option premium built in to boot.
- Although the near-term inflation prints will come down, the increase in longer-term breakevens means that expectations of the forward price level will continue to rise. The chart below shows the level at which December 2027 CPI futures would be trading, based on the inflation curve, if some exchange actually had the courage to launch CPI futures. One year ago, the implied forward level of 310, compared to the November 2020 level of 266.229, implied that the market expected inflation from 2021-2027 to average 2.2%. That was in the thick of the “it’s transitory” baloney. Today, the theoretical futures suggest that inflation from 2021-2027 will average 3.6%, and that even ignoring the inflation we have seen so far, the price level will rise 3.25% per year above the current level over the next 5.75 years.
- Stocks are going to decline. It is a myth, unsupported by data, that stocks do well in inflationary periods. At best, earnings of stocks may increase with inflation (and even exceed inflation in many cases since earnings are levered). But multiples always decline when real interest rates and inflation rise. Modigliani said it shouldn’t happen. But it does. And the Shiller P/E right now is around 40.
- Then, the Fed is going to get nervous. Rising long-term inflation expectations will make the FOMC think that they should keep hiking rates, but the declining equity market will make them think that financial conditions must actually be tighter than they seem. And they’ll be afraid of causing real estate prices, which have risen spectacularly in the last couple of years, to decline as well. They will, moreover, be cognizant of the drag on growth caused by high food and energy prices, and in fact they will forecast slower growth (although it is unlikely that they will forecast the recession until it is over). And, since the Fed believes that inflation is caused by too much growth, rather than by too much money, the Committee will slow the rate hikes, pause, and possibly stop altogether. This is, of course, wrong but being wrong hasn’t stopped them so far.
- Long rates will initially benefit from the notion that the Fed is abandoning its hawkish stance and because of ebbing growth, but then will continue higher as inflation expectations continue to rise. On the plus side, this will keep the yield curve from inverting for very long, ‘signaling a recession’, but a recession will come anyway.
- Inflation by that point will only be down to 4-5%, but the Fed will regard what remains as ‘residual bottlenecks,’ since in their models a lack of growth puts downward pressure on inflation. They’ll stop shrinking the balance sheet, and may well start QE again if the decline in asset prices is steep enough or lasts long enough, or if real estate prices threaten to drop.
There you go – that’s my road map. I am not married to this view in any way, and am happy to discard it at any time. But I know what I am going to do when the market does what it is going to do. You should too!
Tight Spreads’ Cost: Orderly Markets
In this article I am taking a brief break from writing about inflation. There have been lots of great stories and anecdotes recently about inflation. I loved the Wall Street Journal article about how “Inflation and Other Woes Are Eating Your Girl Scout Cookies”, and we have seen several contributions from former Treasury Secretary Larry Summers that are worth reading. One was an opinion piece in the Washington Post (“Opinion: The stock market liked the Fed’s plan to raise interest rates. It’s wrong.”) and one was a very good NBER working paper on “The Coming Rise in Residential Inflation,” in which he confirms and extends the normal way inflation people forecast rents and comes up with even higher numbers than I’ve been working with for a while. Incidentally, if you haven’t seen these stories before now, consider installing the Inflation Guy mobile app. I don’t curate every single inflation story; just the ones worth curating.
Moreover, the Fed increasingly sounds like they want to be aggressive with rates. That’s half the battle, though on the more important half (the balance sheet reduction) they don’t yet have a plan. I should note that saying hawkish things on half the plan isn’t really all that hawkish, especially when your notion of “pushing rates above neutral” means 3%: a level well below inflation. But it’s progress that these folks have finally realized that inflation is a real phenomenon and not just due to port congestion. They still don’t seem to see the role of money growth in causing that phenomenon, but it’s nice we’re making baby steps.
As I said, though, in this article I’m going to talk about market structure, and the deal with the devil we have made to seek ever-tighter-spreads at a cost of orderly markets.
Since the 1970s, the cost of trading equities has moved from a bid/offer spread of a half point or a quarter point ($0.50 or $0.25 per share), on round lots, plus large brokerage fees, to sub-penny spreads on any size trade, often with zero brokerage costs. The cost of bond execution has similarly declined, as has the cost of futures and swaps brokerage. Volumes, across all markets, have responded to the decrease in costs. Some of this improvement in the median cost of trading has come from increased transparency, and a lot from increased competition.
Those improvements have not come without a cost, but at most times the cost is less apparent. The way the stock market used to be structured was around a number of market-making firms whose job it was to maintain orderly markets – including the distasteful task of being the buyer when everyone else is selling. What this means for the profit of a market-maker is that they generally made steady, small profits (a quarter of a point on every share, day in and day out) and occasionally lost huge amounts in market panics. It’s a classic “short gamma” position of picking up nickels before the bulldozer, and well-understood by the market-makers to be so. But that was the deal: you let the market-maker take his spread as an insurance premium, and collect on that premium when a calamity hits. Primary dealers in the government bond markets worked the same way: in exchange for the privilege of building an auction book (and being able to bid on the auction with that knowledge) and making spreads as a market-maker most of the time, it was understood that they were supposed to work to keep markets liquid in the bad times.
Then, we decided that we didn’t like paying all of these insurance premiums, which we called the “cost of trading” but could also be considered “the cost of providing continuous liquidity in bad times.” So stock prices were decimalized, which immediately started narrowing spreads. Electronic trading made the deal even worse because anyone could jump in front of the market-maker and be the bid or the offer, meaning that the market-maker wasn’t earning the spread. In many cases, there wasn’t any spread left to earn.
There is a parallel to something else I’ve written about recently, and that’s the trend over the years to lower and lower costs, and longer and longer supply chains, in manufacturing. Such a system is lower cost, but the price of that cost-savings is fragility. A long, international supply chain gets snarled much more easily and much worse than a short, domestic one. That cost/fragility tradeoff is the bargain that manufacturers made, although not thoughtfully.
Similarly, the price of the cost-savings from sub-penny equity spreads is fragility in the market-making system. It is difficult to find dealers who will accept the responsibilities of being the buyer or seller of last resort, and maintaining orderly markets, when that cost is not counterbalanced by an increase in profit opportunities during placid times.
As with international trade, we have begun to see the downside of this tradeoff when trading risks increase. Not that this is the first time, but it seems these days that liquidity conditions get sketchier more quickly now than they used to. Of course, we saw this as recently as March 2020, when trading in credit got so bad that the Fed had to step in and backstop corporate bond ETFs by buying corporate bonds and ETFs under the Secondary Market Corporate Credit Facility.[1] Recently, the Nickel market basically broke when prices went vertical and the resulting margin calls would have put some LME brokers out of business (conveniently, the LME decided to just cancel the trades that they didn’t like, which means those brokers are still in business but probably won’t have a market to broker). Prices went vertical partly because there are fewer highly-capitalized market-maker shops to stand in the middle and make orderly markets. Also recently, the European Federation of Energy Traders pleaded for “emergency funding mechanisms” so that they can continue to trade energy markets that have had greatly increased volatility recently.[2]
Now, the disturbing thing is that we are starting to see declines in liquidity even in fairly unremarkable periods. The last seven months’ worth of volatility in interest rate markets was higher than we’d seen in some years, but not exactly unprecedented. This month, 10-year Treasury yields are up 57bps. In 2002, 10-year yields fell 170 bps between May and October, in something close to a straight line driven by mortgage convexity. In about 6 weeks from May to June in 2003, yields dropped 81bps and then immediately reversed 129bps higher over the ensuing 6 weeks (same reason, different direction). I mention those two episodes because I was making markets in rates options and remember them not-very-fondly.
But these recent 57bps have been a lot more stressful on the market with fewer strong hands responsible for maintaining order. The chart below shows the BofA MOVE index, which measures normalized implied volatility on 1-month Treasury options. Recently, that index reached its second-highest level since the Global Financial Crisis. The highest prior level was in the March 2020 shutdown crash…understandable… and during the GFC banks were undercapitalized and in risk of failure. What’s the reason now?
We also see it in various market ecosystems. For example, there are roughly two dozen “Lead Market Makers” in the ETF ecosystem. In order to launch an ETF, you need to find someone to be the LMM. The function of the LMM is to make markets in virtually all conditions. But it is exquisitely hard to get an LMM signed up nowadays because the math for them works out badly. If your fund is very small, they make a decent spread but on tiny volume so it’s not very lucrative. As soon as your fund gets large, everyone else jumps in front of your markets, because they can and there’s money there to be made, so the LMM either makes no spread at all or makes a very small spread. Of course, those other Johnny-come-latelies will scatter the first time there is volatility, leaving the LMM there all alone to make orderly markets. So the market-making itself is a bad deal for the LMM in almost all circumstances. Their models are only tenable if they are able to make money on the relationship with the ETF issuer in other ways – being a broker for fund rebalancing, etc. This means that fewer good ETFs come to market than otherwise would. I have lamented this elsewhere. And the root cause and ultimate result are the same: we’ve engineered a very low-cost, high fragility system for investors to deal in.
The bottom line is that as any insurance agent can tell you people really hate paying for insurance. But no one expects insurance companies to provide insurance without being paid at least a fair premium. What would happen if we did? Well, then we wouldn’t have any insurance. Financially speaking right now, we don’t have much insurance because it’s too costly to stand in the middle. That looks like a win, until something catches on fire.
[1] For the Fed to buy corporate bonds was long held to be impermissible, since the Federal Reserve Act listed the assets the Fed was authorized to buy and that list did not include corporates and equities. Clearly, this was meant to follow Bagehot’s dictum that a central bank, to avert panic, “should lend early and freely, to solvent firms, against good collateral, and at ‘high rates’”, but thanks to clever lawyers who note that the Act does not explicitly prohibit the Fed from buying these things the Fed has in recent years decided that since it wants to, what could go wrong?
[2] A sad aside is that the movement to remove “pricey, greedy market-makers” and replace them with bailouts provided by central bank or treasury is the opposite of what Dodd-Frank was supposedly trying to do in ensuring that systemically-important institutions were adequately capitalized. They’re adequately capitalized now, but they don’t provide the market-braking function they used to because that’s ‘speculative activity’ that penalizes capital severely.
Summary of My Post-CPI Tweets (February 2022)
Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Get the Inflation Guy app in your app store! Check out the Inflation Guy podcast!
- Well, here we go! It’s #CPI Day, which this month happens to fall on the day after an intraday 60-cent drop in gasoline futures. THAT will clear your sinuses!
- Before the walkup, let me tell ya that I will be on @TDANetwork today with Nicole Petallides @Npetallides at 11:50ET. Tune in!
- Also, when I am done with the tweets today I will post a summary at https://mikeashton.wordpress.com . Later it will be podcasted at http://inflationguy.podbean.com. And all of that also will be linked on the Inflation Guy mobile app. Now with those preliminaries…let’s dig in.
- We will get fresh 40-year-record highs again today, with the consensus calling for 0.8% m/m on headline (7.9% y/y) and 0.5% m/m on core (6.4% y/y).
- The last four m/m core inflation figures have been tightly clustered from +0.523% and +0.603%, so the forecast is not terribly adventurous. There have been a few calls for hitting 8% y/y today, but I think some of those are so people can say they called for 8%.
- We will get there next month, so no hurry.
- That tight cluster of recent prints is really the main thrust of the story. The distribution of monthly core inflation is no longer around 0.2% per month or a little less. It’s around 0.5%. Hopefully we can get that down to 0.4% or even 0.3% eventually. But we’re not there now.
- I should say that’s the main thrust of the CONTINUING story. This month, we have other stories courtesy of Vladimir Putin.
- But, as a reminder, this inflation debacle started LONG before Russia invaded Ukraine. And it was committed with a worse weapon than a gun: the printing press. You can hide from a gun. You can’t hide from the printing press.
- The Russian invasion caused disruption in the supplies of many commodities and helped spike energy prices. But remember, these are commodities. As long as Russia sells to SOMEONE, the eventual effect on energy prices will be much less than the short-term effect.
- We covered this before with Chinese purchases of soybeans. So if Russia is constrained to only sell energy to, say, China, then China needs to buy less from, say, Saudi Arabia. Which means the Saudis have more to sell to us, or whoever previously got it from Russia.
- Commodities are pretty similar. Part of the definition. So it disrupts the flow, but gasoline doesn’t spoil (ok, sure, it spoils, but slowly). I’m much more worried about wheat. If you don’t plant wheat this spring in the Ukraine, there will be less wheat globally for the year.
- Now, unlike raw gasoline, which we consume in its commodity form and so shows directly in the CPI, raw food commodities don’t take the same path. Your Cheerios have oats, but they also have a lot of packaging, transportation, advertising, and so on.
- That said, these large and sustained increases in energy affect food inflation through transportation, packaging, fertilizer too. Add to the impact of the war on planted acreage and you have the ingredients for a SUSTAINED increase in food prices for a while.
- We usually look past food and energy, and focus on core, because food and energy mean revert pretty quickly. They won’t, this time, as quickly and that’s part of why CPI is broadening. And it’s why even after the peak, inflation won’t automatically recede on base effects.
- Also, if energy prices spike, there is no guarantee it will affect other products so much because producers can smooth through spikes. A spike in wheat need not impact wages. But SUSTAINED increases in prices seep into those other goods and services. And they have.
- …about wages, which is another interesting and important story. The Atlanta Fed Wage Growth Tracker, for my money the best measure of overall wage pressure since it focuses on continuously-employed people, is up at a 5.1% y/y pace.
- Wages by that measure have actually been tracking pretty well with Median CPI. The chart of Wages minus median CPI is weirdly stable given everything that is happening. Implication?
- What that says is that far from “not engaging a wage-price spiral,” the labor force is actually being uber-efficient at getting their wages adjusted. On average, of course, and adjusting for median not core. Median is a better sense of the middle – not driven by used cars, e.g.!
- Does all of the transparency, the “Indeed.coms” of the world, make it easier to have a wage-price spiral because workers adjust their wage demands more quickly with better information? I wonder.
- Back to the market and today’s figure. Here are the market changes over the last month. Yes, 1-year inflation expectations are +150bps. 10-years are +45bps. 10-year real yields are -44bps. (No surprise, with real yields down, gold is +8% over that timeframe). This is dramatic.
- Wanna know what scares me? This chart. Money supply growth is still at 12% y/y, which is bad. But see commercial bank credit? It’s ACCELERATING. Concerning. The Fed directly controls neither of these, when they don’t control the marginal reserve dollar.
- Now, for the CPI today. Rents will continue to boom, and used cars may settle back slightly. There are some signs of that. But that’s the fireworks. But I am gonna watch pharmaceuticals, and food & energy, more than usual.
- The real excitement there will be NEXT month – this is Feb’s number and the Ukraine invasion hadn’t happened yet. Whatever today’s figure shows, it will just be the jumping off point for the March spike.
- The interbank market still has the peak headline CPI in March (March 2021 was +0.31 on core, but April was +0.86, so it will be hard to have a new high in core at least after March), but now it has that peak at 8.55%. Go ahead, gasp. It’s a gasp kind of number.
- That’s it for the walkup. Look for weakness anywhere in the number – won’t be much of it, so relish what you find. We no longer need clues about whether inflation is coming. It’s here. We need to start finding clues about a deceleration beyond base effects. Haven’t seen any yet.
- The economists nailed this one. 0.8% on the headline, 0.51% on core (6.42% y/y on core). Yes, all 40+ -year highs. And still pretty much in the zone. Trend core inflation is right around 6-7% at the moment.
- As expected, used cars fell a little, -0.25% m/m. But y/y still rose, to 41.2%. Other of the “COVID Categories”: airfares +5.2% m/m, lodging away from home +2.2%, new cars/trucks +0.3%, motor vehicle insurance +1.8%, Car/truck rental +3.5%. Ouch all around.
- (of course, since they’re covid categories, lots of people will want to strip out all of that).
- Food & Beverage major category: +1% m/m, up to 7.62% y/y. That’s the largest y/y rise in that category of CPI since 1981.
- Core Goods at 12.3% y/y. Core Services 4.4%.
- Rents: OER was +0.45% and Primary Rents +0.57%. Both represent accelerations over last month. Y/Y is at 4.3% for OER and 4.2% for Primary.
- Medical Care continues to be a conundrum. Overall, that category rose 0.17% m/m after +0.85% last month. Pharma was +0.4% and continues to be the strong one. Doctors’ Services fell again. And this month Hospital Services also fell. I don’t understand that at all.
- Core inflation ex-housing was 7.60%. in March 2020 it was 1.49% and it fell to 0.33% in May 2020.
- Apparel, +0.72%. Recreation +0.73% m/m. “Other” +1.06% m/m.
- Within Food & Beverages: Food at home (8.2% of the CPI): +1.4% NSA m/m; +8.6% y/y. Food away from home: +0.4% m/m, +6.8% y/y. Alcoholic Beverages +0.9% m/m, +3.5% y/y.
- Food at home AND food away from home both at 42-year highs.
- drilling down, the ONLY categories of food and beverages that declined in price: Fresh Fish and Seafood, -0.70% m/m in NSA terms, Bananas, -0.10%, Lettuce -0.29%, Tomatoes -1.88%, uncooked beef steaks -0.19%, and Pork Chops -0.01%. Most of that was seasonal as y/y accelerated.
- Early guess at Median CPI is +0.54% m/m, which is down only slightly from last month’s spike. That median is now looking like core is what tells you that this isn’t just one-off categories.
- Incidentally, my median estimate might be low…the median categories look to be the regional housing OERs, which the Cleveland Fed seasonally adjusts separately. I’m more likely to be low the way the chips fell. Either way, Median at 4.60% is really disturbing.
- Let’s do the four pieces charts. First, Food & Energy. Unlike prior spikes, this is going to roll over more slowly. The rate of change will mean-revert. But the food part I think will remain a positive inflation contributor for much longer than normal (prices will keep rising).
- Core goods. Nothing much to say. This is beyond automobiles. Part of this is pass-through of energy prices (via freight, packaging), so it’s a non-core effect on core. Some are bottlenecks. None look to be easing in the near-term.
- This chart, piece 3, is interesting because about a quarter of this is doctors’ and hospital services, which have been pretty tame so far. And yet, it’s almost at 4%.
- Finally, Rent of Shelter. Almost at 5%. So actually, the core-services piece is holding down inflation now…not shelter. Remember that shelter is the big, slow piece. Some people are calling for OER at 7%. I don’t get that from my models. But still, it’s going higher.
- …and rents are part of the wage-price feedback loop. (Remember that the dip in 2021 was largely artificial because of the eviction moratorium, and everyone knew it, which is why it didn’t change wage demands much).
- Almost 80% of the consumption basket is inflating faster than 4%. About a third is inflating faster than 6%.
- At least by one set of models, the OER rise may be cresting soon. I’m a little skeptical but that’s what the model says. However, it’s not going to turn around and drop, which means core inflation will be high for a while. Not just 2022.
- So I said to look for evidence of deceleration. There’s not much. But there’s a LITTLE. The Enduring Investments Inflation Diffusion Index declined to 35 from 41. That’s not a lot, but it’s in the right direction.
- So wrapping up: there’s no real sign of any ebbing of inflation pressures. In fact, there are some signs that food inflation will stay elevated for longer than the normal oscillation cycle. But we are closer to the end of the spike, anyway, than to the beginning.
- Core inflation will likely peak next month, and headline inflation in the next couple of months. That’s good. But we’re not going to go back to 2%. Right now, the monthly prints point to an underlying core rate around 6%. I suspect we will end 2022 in the 5s, or high 4s.
- If there’s any chance to get to the 3s in 2023, it would be because the Fed starts to shrink its balance sheet with some urgency. I see zero chance of that.
- In fact, as I’ve long said – the Fed is not going to tighten at every meeting. They’ll have excuses to skip meetings and assess.
- For example, although Russia/Ukraine has nothing to do with monetary policy, it took 50bps off the table for this month – we will get a 25bp cosmetic hike in rates – and probably means they skip next meeting. And then once inflation peaks they’ll want to see how fast it ebbs.
- Don’t want to overtighten, you know. The net result is that inflation is getting embedded in our psyche and it will be very long until we get 2-3% core inflation on a regular basis.
- That’s all for today. Thanks for tuning in. Catch me on @TDANetwork at 11:50ET and look for my tweet summary at https://mikeashton.wordpress.com . Curious what tools we’re working on in inflation? Stop by http://enduringinvestments.com . Subscribe to my podcast. https://inflationguy.podbean.com Etcetera!
Core inflation for the last 5 months has been in a tight range suggesting 6%-7% is the underlying trend rate; this started long before Russia invaded Ukraine. The invasion means that food inflation will take longer to ebb than it usually does, as not only are we getting pass-through from the extended period of high energy prices (affecting freight, packaging, and fertilizer) but we’re also seeing plantings in Ukraine likely to be disrupted. But it isn’t just food and energy, but everything across the board. A plurality of the consumption basket is inflating faster than 6%!
And this is seeping into wages, and quite quickly at that. Wages are actually adjusting to the level of unemployment more quickly than history would suggest they should be. Based on where unemployment was 9 months ago, the Atlanta Fed Wage Growth Tracker should be around 3.5%. Based on where unemployment is now, it should be around 5%. It’s already there.
I showed a chart earlier illustrating that wages are not trailing inflation in the way that we normally expect that they would. Workers, possibly because there’s been so much turnover thanks to COVID and possibly because of the transparency of wages these days, are getting wage adjustments that keep them about where they historically have been with respect to inflation. That’s remarkable, but also problematic if there is anything to the “wage-price-spiral” thought process.
But at the end of the day I still don’t think the Fed is willing to move fast and break things. In the classroom, the Taylor Rule says they are dramatically behind the curve and should be hiking rates. Of course, the classroom also says that they should do that by adjusting reserves, which they no longer do, so the textbook is clearly flexible. But in the real world, Fed moves do not happen on paper and they don’t just move prices and output. They also crack over-levered entities and cause financial distress in unexpected places that leads to other bad things. The Fed has “learned” this over the years and it’s one of many reasons that I don’t think we’re going to see 200bps of tightening. And probably not 100bps of tightening, in 2022. They will be cautious, measure-twice-cut-once, speak sagely and calmly in the press conferences, and hope to God that they haven’t really messed it all up.
They have.
Anatomy of a Monetary Policy Error
Well, it isn’t as if no one warned that monetary policymakers were eventually going to get painted into a corner. Long before the Covid crisis, there were many voices warning that the Fed’s tendency to ease aggressively, but to find excuses to tighten slowly, would eventually get them into trouble. And here we are.
The Federal Reserve, prior to the Ukraine/Russia war, had started to talk hawkishly about raising interest rates; that talk, combined with 40-year highs in core inflation, persuaded Wall Street economists that the Fed would raise interest rates by more than 200bps this year.
That was never going to happen, even if Russia had not invaded Ukraine. Not since the early 1980s has there been a tightening cycle of at least 200bps over 10 months that also ended with the overnight rate above where the 10-year rate had been at the beginning of that period. So the calls for 200bps of tightening with the 10-year rate under 2% was always an incredibly aggressive call. Moreover, those cycles where it did happen occurred in an era when the Fed Chairman didn’t go in front of the cameras every meeting to explain why the Fed was ‘trying to increase unemployment’ – and, in fact, back in those days almost no one outside of the financial community paid much attention to the Fed at all. Plus financial leverage, ancient source of dramatic accidents, was much lower then. So my operating assumption has always been that the Fed would probably tighten about 3 times this year, pausing in between each hike…or maybe hiking 4 times and then easing once. Especially since the Fed no longer controls the marginal reserve dollar (there being copious excess reserves), the effect of monetary policy moves is less clear…and this also mitigates in favor of taking time to assess the effect of policy moves by watching the economy evolve. Ergo, this tightening cycle was always destined to be late and halting, and focused on interest rates rather than on money supply. Such a trajectory already qualifies as a ‘mistake’ when inflation is threatening 8%.
But now there’s even more room for error. Because the skyrocketing energy prices trigger another mistaken belief at the Fed, which enhances the desire to tighten even slower/later.
The Fed thinks that rapid energy price increases have this effect on the economy: rapid increases in energy prices tends to cause slow growth or recession as those increases consume discretionary income and leave less for non-energy purchases. And recession causes a decrease in pressure on other resources, such as labor. Which, in turn, leads to lower pressure on core inflation. Since energy prices are mean-reverting (at least, the rate of change is!), the central bank is “supposed” to ignore inflation that is caused by energy price increases, since if they tighten according to some Taylor-Rule-like dictum then they’ll tighten into a recession and increase the amplitude of the business cycle. Ergo, the Russian invasion of Ukraine means that the Fed should tighten less.
However, that’s not the way this works.
Rapid increases in energy prices do in fact tend to cause recession. But inflation is not caused by too little economic slack, and disinflation is not caused by too much slack. Inflation is caused by money growth, period, and M2 money growth is currently above 12%. It is true that an increase in energy prices would lead to a decline in non-energy discretionary spending, which would limit core inflation, if money growth was low. But if money growth is high, the increase in energy prices just rearranges the relative price changes because there is plenty of money to go around. It doesn’t change the overall impact of the rapid money growth. (Small caveat: a scary recession would increase the demand for precautionary cash balances, lowering money velocity…but people are already holding such precautionary balances so it’s hard to see how that could be a large effect from this level). Ergo, when the Fed slows down its tightening campaign because of the way they believe inflation works, and especially if they decide to not shrink the balance sheet – because “higher long-term rates would be bad in a recession” – they won’t have any real effect on growth but they’ll be accommodating a much higher level of inflation.
And just like that, you have it. The genesis of a really colossal monetary policy error. Get ready.
