Don't freak out about the...

Inflation may prove to be transitory, but the debate surrounding it won't!

Many people hear inflation, but think prices! When the Fed says inflation is likely to prove transitory, they mean that the pace at which the price level is rising today is unlikely to sustain for a long time. Most of those who contest this, are implicitly (and wrongly) thinking that the Fed expects prices to fall next year - which isn’t true because that would be deflationary, not transitory! The Fed expects prices to rise next year, just not at the same pace at which it has increased over the last couple of months, but closer to the longer-term trend. Therefore, the valid questions to ask here are:

1. What gives them the confidence to argue that inflation will moderate back to the long-term trend?

2. How long will they take to know whether it indeed proves to be transitory or not?

3. What can they do if it doesn’t prove to be transitory?

4. What path will the market price over the coming months?

Let’s go through each of those questions. Here’s a chart of the twelve-month average month-on-month change in headline CPI:

Over the last three decades, the average monthly change in CPI has been between 0.10%-0.30% most of the time - 90% to be precise! That’s a very long, secular trend to be suddenly sabotaged by what seems like a cyclical push, albeit with some added flavors. Globalization (outsourcing) and technology (automation) have been two major drivers of prices in this century, and it’s unlikely they will allow margins to build up in any corner for a meaningful amount of time. Now, this secular trend is being challenged (and for now, overcome) by a confluence of factors, cyclical, and indeed, very unique to this cycle, that is pushing prices up at a record pace.

A re-opened economy brings with itself the urge to spend accumulated savings from government handouts. This creates demand for goods, services, and labor, but the supply of labor remains tight, potentially due to incomplete vaccination, parental duties, higher unemployment insurance payments, and perhaps some early retirements. These labor and other supply-chain disruptions are not confined to the US alone. Prices are bound to rise sharply in these circumstances. Used cars and the semi-conductor shortage, airfares, etc that are leading the pack fit the description.

Now, the Fed looks at inflation somewhat differently than other market and non-market participants. While they target PCE (Personal Consumption Expenditure) to average around 2%, they often look at the core and trimmed measures of inflation to identify whether the move (upwards or downwards) in prices is driven by volatile categories, or by some outliers. And if you’re wondering what difference does that make, here is a chart for you:

So, the reason why the Fed should feel confident about high inflation proving transitory is that it’s being led by outliers and none of the factors driving the surge - accumulated household savings, transfer payments from the government, base effects on oil prices, reopening or supply-chain disruptions are likely to last beyond a few months. Moreover, while the only historical precedent being cited these days is the 1970s and Weimar, one would do well to remember 1937 and 2011 as well. In a splendid article, “Commodity prices and the mistake of 1937: Would modern economists make the same mistake?”, written in June 2011, exactly a decade ago, Gauti Eggertsson argued against tightening based on the experiences of the 1930s:

“The Mistake of 1937 was a preemptive policy tightening in a fragile economic environment. Specifically, it was a decision to abandon the policy of “reflation” introduced in 1933… to relinquish the benefits of reflation and to set all policy levers in reverse. The Fed and key administration officials hinted at interest rate hikes and endorsed austerity in fiscal policy; the key concern now was containing inflation rather than sustaining recovery.”

The only real risk to this view is if the trimmed medians start moving up on account of the increase in shelter/OER prices, which account for nearly a quarter of the consumption basket. A jump in these prices will most likely push the median measure higher. As we can see here, rents are lagging the growth in house prices, possibly because of temporary moratoriums, indicating there is room for rents to rise.

Even that, however, is likely to be a few upward adjustments this year. Therefore, the only way for the Fed, or anybody for that matter, to tell whether inflation is to return to the 0.1%-0.3% range or settle at a higher one, is to wait for data till the end of the year. If the trimmed measures of inflation are still holding up, it would mean that rate hikes are required. If not, that would be an indication that by this time next year, we would be back to unremarkable inflation prints. This is also consistent with what Vice-Chair Clarida had said when asked about how long would it take to determine whether inflation is transitory or not.

If it does prove to be transitory, then the Fed can let the labor market run hot for a long time. Here it’s important to note here that although the Fed’s mandate of ensuring price stability and maximum employment hasn’t changed itself, the meaning of “maximum employment” has, with NAIRU (equilibrium level of unemployment) taking a backseat. This allows the Fed to look past the solitary unemployment rate, and focus on the spread between colored and white employment, the employment-population ratio, wages at the lowest quartile of workers, discouraged workers, and those who are working part-time for economic reasons. And as we can see in the chart below, the economy is close to two years on current trends from pre-covid levels in employment, which may or may not be satisfactory for the Fed.

On the other hand, if it doesn’t prove to be transitory, then the Fed will of course tighten financial conditions, first by ending asset purchases and then, if required, via rate hikes. The pace of tightening, however, would depend on the state of the job market at the time and inflation expectations in the market. If the labor market is far from full employment, the Fed would assume that financial conditions tightened by the ending of QE and the eventual return of workers would be enough to calm such pressures down. This would be especially true, if inflation expectations remain as well-anchored then, as they are today (as seen below).

Of course, if inflation expectations are high and employment is also rising steadily, the Fed will have no problems raising rates back towards neutral or perhaps even beyond that. This brings us to the path of policy ahead. So, here is how this plays out:

Over the next few months, we would get some large inflation readings, mostly shelter-driven. There will be some voices on how “this time it’s different”. The Fed will continue to question the sustainability of these prints, keeping an eye on the trimmed measures and another on inflation expectations (5y5y). If both of them are in check, they will continue to say “we think it’s transitory but we are watching it closely and will act if we have to”.

Markets will of course keep some hikes priced in for 2022/23, irrespective of whether we get good or bad non-inflationary data. The spreads beyond that, however, will tighten/widen in response to employment numbers. Come Q4, if this trimmed median doesn't change its trajectory back towards 0.25%, then the FOMC would stop characterizing these high inflation prints as being transitory, and signal lift-off in 2H 2022. Markets would re-adjust hike odds, aligning them to the guidance.

A word on the current market reaction: Yes, it does seem contradictory to focus on the dots for 2023 while completely ignoring the longer-run ones, or to think that the great inflation threat that looms over us like the sword of Damocles can be evaded by a few hikes. The current setup is justified only if it is assumed that the Fed will end up making a policy error, hiking too soon, killing inflation expectations, and with it, their only chance to escape the Zero Lower Bound (ZLB).

In short, the difference between the Fed’s view and the market’s view is not so much on whether or not high inflation prints are going to prove transitory (markets agree with that view, as is evident in the inverted slope of the break-evens curve), but on whether or not the Fed will be able to hit both their goals - of PCE averaging 2% over time and unemployment falling towards NAIRU. Hence, the curve has room to settle higher, even if at a flatter slope, although for now, the market seems to require more evidence (in terms of payrolls) to respect the longer-run dot.

This brings me to my conclusion: Consensus is that the Dots imply the Fed has abandoned FAIT or that it somehow vindicates some in the market. In my opinion, the Fed should be delighted to see the reaction in the market. This is because prior to this “episode”, there was a lot being said about the Fed's ability to control inflation expectations (should they get unhinged). However, the mere hint of a couple of rate hikes, two years out was enough to calm longer-term inflation expectations.

Therefore, this episode actually should give the Fed the confidence needed to remain data-dependent, as they know now, that they can tame inflation expectations if they want. So, if anything, data notwithstanding, it's now less likely that we get a rate hike next year than more. Note the caveat there – data notwithstanding! Of course, if the data is great, the Fed would be happy to hike. They have been wanting to get away from the zero-lower-bound for so long since it limits their ability to do policy.