A Tighter Fed Policy Could be Inflation Overkill

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As inflationary pressures were building in mid-2021, Fed Chair Jerome Powell maintained that he and the other Fed leaders believed that inflationary pressures were “transitory,” as he claimed at a Senate Banking Committee hearing in November 2021.

“We will use our tools to make sure that higher inflation does not become entrenched,” Powell said.

Instead, the Fed kept quantitative easing (QE) in full force until March 2022, as inflation rose to 6% by the end of the year, citing that central bank officials didn’t want to “shock the market.”

Well, Powell’s speech in Jackson Hole last Friday did shock the market, and was as if he was mad at the world and at how history will remember his legacy, as a “Johnny come lately” Fed chairman who was tardy in addressing inflation followed by issuing a monetary policy that will overshoot when inflation data are already in decline.

The Fed’s most favored inflation data point is the Personal Consumption Expenditures Price Index (PCE). For July, the forecast was for a month-over-month increase of 0.6%, and instead came in at 0.2%. Personal spending rose just 0.1% month-over-month, versus consensus 0.4%, following a downwardly revised 1.0% increase from 1.1% in June. The PCE Price Index declined by 0.1% month-over-month versus a consensus of 0.1%, which left it up 6.3% year-over-year versus 6.8% in June — a clear move lower in the right direction.

The core PCE Price Index, which excludes food and energy, increased 0.1% month-over-month versus consensus 0.3%, which left it up 4.6% year-over-year versus 4.8% in June, also moving lower in the right direction. Chair Powell made no mention of these improving data in his speech, which I thought was inappropriate. Disinflation is underway, and rather than acknowledge that inflation has probably peaked in the United States, Powell talked of pain for households and businesses and raising interest rates to fight inflation “until the job is done.”

Gas prices have retreated by 23% from the June high, and prices for crude oil, wheat, corn, soybeans, cattle, lean hogs, sugar, cocoa, orange juice and lumber are all trading off their 2022 highs, setting the course for further declines in headline inflation data for August. The only commodities hitting new highs are natural gas and coffee. There is a famous saying in the commodity market that “the cure for high prices is high prices.” This self-correcting mechanism leads to higher supply and a fall in price.

More importantly, the institutional smart money that trades in the inflation swaps market is trending toward lower inflation. An inflation swap is a transaction where one party transfers inflation risk to another party in exchange for a fixed payment. Swaps are used by professional traders and fund managers to hedge inflation risk. An inflation swap can provide a pretty accurate estimation of what would be considered the “break-even” inflation rate. The one-year forward Secured Overnight Financing Rate (SOFR) is now at 2.7%, where it has been pegged at that level since mid-June.

Markets are nervous because Jerome Powell implied inflation will be around for a long time, but the swaps market is trading with a definite lower level in the forecast for the next year. He noted that Fed policy will pivot when the pace of inflation is on a trajectory to be under control, and after losing so much credibility standing its ground with the “transitory” rhetoric, the Fed is not about to make any new predictions.

As Fundstradt’s Tom Lee so insightfully noted on Friday, the drivers for rising, or accelerating, inflation have essentially evaporated. Housing is in a significant downturn, as inventories are approaching levels not seen since the great financial crisis. High demand durable goods, like cars and furniture, that were bid so high due to supply-chain issues are now seeing lower demand, even as prices fall.

On the topic of wages, Lee cites that high-frequency measures, such as job openings from Indeed.com, are down more than 40%. Wage growth doesn’t have to get down to zero to meet the Fed’s inflation target. It has to fall about 1-1.5% from its current 5% level to be consistent with the actual overall inflation rate of 2%. Recent monthly job growth is a result of workers taking on second or third jobs. Single-job-holder growth of the past two months has actually declined. It’s not as great a labor market as is touted.

The stock market ultimately takes its cue from the bond market, where, by the close on Friday, the 10-year Treasury note was at 3.04% in very stable trading. For the Treasury market to end the day flat after that ultra-hawkish speech by Powell is telling. Another key data point is that consumer expectations of future inflation are falling, and for the third month in a row, the University of Michigan surveys show consumers are seeing lower inflation for the next one and five years. I’m not being dismissive of the risk of global macroeconomic events, but the S&P has already fallen by 27% from peak to trough, which likely priced in the current technical recession evidenced by two quarters of negative gross domestic product (GDP).

The high prices for homes and durable goods are arguably just going through an adjustment from COVID-19-inflicted shortages, implying a soft landing that runs counter to the consensus that overwhelmed the market last Friday. This trend should also start showing up in the used car market and travel industry, where prices have been very elevated, and are big components to CPI data. Once investors and the market see the collection of these softening trends in place, the narrative will likely turn positive as early as late September, where those that buy this pullback will be well rewarded.

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