Inflation Is Back

This morning’s CPI release was much as expected. CPI came in at 6.5% higher than a year ago, while being 0.1% lower than a month ago.

Markets celebrated this confirmation of a reduction in past inflation with a renewed inflationary surge. Even the most speculative of markets, cryptos such as bitcoin, are taking an ominous turn higher.

One of Financology’s perennial theses is that declines in the value of the dollar show up first in real time asset markets, later in goods and services markets. The monthly decline in CPI is a case study of this phenomenon. Stock and bond prices had declined sharply over the past three quarters into a bottom around the beginning of October. In December, the CPI declined.

The market response is a case study in irony. The dollar has since declined across global markets, against bonds, against stocks, against gold. This on a narrative that the softening of official inflation data imply a less hawkish Fed. It’s more than plausible that not only does the February 1 FOMC announcement bring a smaller 25 bp Fed funds hike, but that it is the last of this hiking cycle. But this same increment of dollar decline is an also a new inflationary impulse that will flow into upward pressure on consumer prices in coming months. First the dollar declines in capital markets, later it declines in consumer markets. We saw this vividly in the surge in bonds, stocks, and gold starting in March 2020, followed by a surge in CPI over a year later.

Big picture: We had inflation in 2020-2021, deflation in 2022. Now we’re back to inflation again.

What could intervene? If the dollar were to resume its ascent in real time markets, that is, if asset prices again reverse lower before the effect flows all the way through the pricing chain, progress on consumer price inflation could be maintained. This could happen in any of multiple ways, but one is that a moderately hotter CPI could trigger another asset price decline. It could also be that the tightening that has already taken place finally takes its toll on corporate profits or that somebody gets too bullish on asset prices (bearish on dollars), becomes overleveraged (shorts dollars), and triggers a “financial crisis” (short squeeze).

This could finally end this cycle of consumer inflation. Followed by another domino of irony, resulting in a mental all clear for the Fed to slash rates and resume printing money, kicking off the next cycle of inflation.

So what’s this all mean for the markets over the coming weeks and months? For now, bullish. We have a profoundly inverted yield curve. This is historically very bearish for stock prices. But increasing short term interest rates are broadly bullish for stocks. The difference is in the timing. An inverted yield curve is not an immediate bearish omen for stocks … the big trouble typically comes in when the yield curve uninverts. First long rates decline (prices rise), inverting the curve, then short rates decline, univerting the curve. Both phases are bullish for bonds, but only the first is bullish for stocks. The second phase has brought the deep declines in stock prices. So I believe my Novermber suggestion that the bear market’s half time show was over was premature … it is still running. Think of when the three month Treasury yield stops rising as a first warning, and when it starts falling as the second.

I can’t emphasize strongly enough, however, that what “stocks” are doing is not an absolute reality. While stocks are “up” in terms of dollars, they’ve sold off sharply in terms of gold, and in fact are back near their October lows. So looked at more critically, what we’ve seen isn’t bullish stock action, but bearish dollar action … aka inflation.

What happens if stocks don’t resume the bear market? This is the Catch 22. If this is a new bull market, consumer price inflation will turn up again, powerfully. This triggers a decline in stock prices … which is reminiscent of the logical exercise known as proof by contradiction … assuming the premise leads to paradox. So while we can’t confidently predict the timing of the second half kickoff, we can be pretty confident it’s still out there waiting…

13 thoughts on “Inflation Is Back

  1. jk says:

    the low participation rate is likely to keep employment relatively tight compared to prior post-wwii slowdowns. between that and the stock market’s propensity to see a pivot behind every tree, i suspect short rates to stay high for quite a while. the federal deficit, however, will grow more sharply as interest payments rise with each refunding, and i assume this will put pressure on the whole curve.

    how do you think markets will perform when the republican house forces first a gov’t shutdown and then a u.s. default?

    1. Bill Terrell says:

      I don’t see a huge rise in unemployment either … the first effect on employment would be eating up the excess of labor demand over supply. Unemployment is surplus of labor supply over demand. As the deficit in labor supply morphs into surplus then you start to see higher unemployment stats. All of this is at the prevailing rate, of course … surpluses of supply in any market are due to prices above market clearing levels. What happens is an increase in the value of the dollar increases real wages. It’s this increase that causes a labor surplus as wages become artificially high due to failure to adjust in nominal terms. In a frictionless market you wouldn’t see unemployment; you’d see a decline in nominal wages as they adjust to the increase in value of the dollar so that real wages remain at market clearing levels. In the near term though neither is likely … as I explain in my post, the dollar is not gaining, but losing value … inflation is back.

      A government shutdown typically brings volatility to the markets. The effects of an actual default would harder to anticipate due to the paucity of precedent. Default is a tail risk … unlikely – usually there’s an eleventh hour deal – but not zero probability. The main thing to bear in mind is that the problem for an overindebted sovereign isn’t fundamentally different whether it misses payments or repays in devalued units … the latter is the normal mode of sovereign default. A transition from that regime to a formal default regime would bring a lot of volatility as markets adjusted to the change. In the longer run though, the rates Treasury pays to borrow reflect its financial standing whether it defaults formally or via inflation. The only sustainable way to keep Treasury’s borrowing costs under control is to keep debt and deficits under control.

  2. Bill Terrell says:

    The remarkable thing is that even after all this Fed tightening … historically rapid rate hikes, shrinking the balance sheet … money is loose again. All last year the dollar gained ground against virtually every other asset. As that filtered through the pricing network, it brought down consumer inflation. But now, at even higher rates, that process has gone into reverse.

    The same rates that would have been highly restrictive a few months ago are now easy. It’s as if markets are responding more to the rate of increase in rates more than rates themselves.

    It’s astonishing, really. A year ago I would have said 3% Fed funds would have been enough to squelch inflation. Who knows … maybe it would have been then … but it isn’t now. The Fed apparently erred in moving to smaller hikes and trying to offset the effect by talking about higher for longer. It’s not working. In a case of be careful what you wish for, the Fed may have pushed its terminal rate much higher than it wanted to.

  3. jk says:

    i think the lower participation rate, leading to higher wages, the supply chain problems, the reshoring/friend-shoring, and the enormous covid-related stimulus packages, have put the economy – or at least prices – on steroids. these all add up to significant inflationary pressures, enough to offset the long-term disinflationary trends which preceded them. i suspect the terminal rate may go to 6.

    1. Bill Terrell says:

      Six percent? That makes even Bullard and Kashkari sound dovish;-).

      But you just highlighted an advantage of focusing on price discovery in real time auction markets. There are no supply chain problems etcetera … or lags there. When the dollar loses value against such disparate things as foreign currencies, bonds, stocks, gold, copper, bitcoin … that decline goes into a pipeline leading to losses against consumer goods and services. You can be sure it’s genuine inflation.

      Supply chain issues like we saw from Covid shutdowns and the outbreak of war for instance aren’t really inflation … the price increases are real, as opposed to reflections of currency depreciation. Conventional economics doesn’t draw a distinction. That includes the Fed, which responds to them just the same as if they were monetary issues.

      But at least in the short run, both views are giving similar answers. Dollar depreciation has resumed. For now the lagged effect of dollar appreciation that dominated the first three quarters of 2022 is dominating final consumer prices at the second derivative level … a decrease in the rate of increase. But the renewed dollar downtrend since then is now filtering in and if it continues will in the coming months stall and possibly even reverse the moderation we’ve been seeing in final goods and services prices.

      This interplay will shape asset market returns. As long as final consumer price inflation moderates, asset price inflation may continue. But if it does, that moderation will end and possibly prompt renewed Fed hawkishness, leading to a second wave of dollar appreciation and asset price declines. I have no analytical tools granular enough to predict exactly when, but I think stocks turn lower again sometime this year. In other words, an extended bear market in two major phases, one of which ended last fall and another that could last into early 2024, separated by the bullish phase we’re seeing now.

      We know Powell isn’t pleased with this “easing of financial conditions”, and it’s possible the Fed leans into it, bringing about an earlier end to this water torture. I would prefer it did, but my base case is that as long as it can point to progress in final consumer inflation, the more dovish contingent has the upper hand.

  4. jk says:

    bls is changing its methodology for calculating cpi, using data from just the prior one year, no longer using data from the prior 2 years. luke gromen calculates this will reduce reported cpi by 200 to 300 bps starting in april. i’m not sure about pce methodology.

    1. Bill Terrell says:

      🙄 Funny you should say that, JK … I’ve had a feeling they might find, uhm, creative ways to get the CPI down, but hadn’t heard of this.

      You might recall our having talked about the government’s incentive not merely to inflate but to inflate the excess of inflation over the CPI, given that such large amounts of government expenditures (SS, TIPS, etc) are indexed to the CPI. This might be just the first new salvo since the Boskin Commission.

  5. Llanlad2 says:

    Darius Dale on a recent Macrovoices interview has similar thoughts on the markets. He thinks there will be more tightening for longer than is priced in but it won’t hit stocks till later in the year.
    He reckons there are two phases to the downturn. Firstly the Fed announces tightening creating a liquidity related downturn. Then later there is a credit based downturn late this year. This hasn’t hit yet as wage increases, labour and household balance sheets are still resilient which is why more interest rate rises are imminent.

    1. Bill Terrell says:

      Thanks for calling that to our attention, Llanlad. Looks like right now markets are priced for probably 25-50 more bp this cycle. If it were to become clear there’s much more than that, that alone will trigger another dollar-rally-asset-price-decline wave.

      The silver lining is that should finally wring enough inflation out of the pipeline to quell this cycle of consumer inflation. It could even stay that way if asset prices don’t turn around and shoot skyward again. But more likely it will trigger complacency, the Fed will slash rates and resume printing again, another wave of dollar devaluation occurs, asset prices take off, and we’re back to the drawing board.

      Despite hopeful talk from Powell et al about not repeating the mistakes of the seventies, I’m afraid the combined pressure from the financial and political elites (Wall and Washington) will be too much for the Fed to resist and it will happen anyway. As it did then, it could take several years of pain before ending it itself becomes a political imperative.

      I also like the point about a credit downturn. So far it’s all been about the dollar … stocks, bonds, gold and other commodities have generally held steady while the dollar moves, creating more or less correlated price movements across asset classes. We haven’t seen much in the way of economic effects that would differentially impact stocks, like meaningful declines in corporate profit margins. I had expected that as early as last quarter, but it hasn’t happened yet.

  6. jk says:

    this is not very different from the commentary that stocks have discounted the change in rates; but not a change in earnings. earnings estimates are still very high.

    1. Bill Terrell says:

      Very much so … the same thing from a slightly different angle. You may recall we discussed this late last summer:

      From 35,000 feet, most of the bear market in stocks to date hasn’t been truly about stocks … rather an appreciation of the dollar depressed nominal asset prices across the board until late October. Then a depreciation of the dollar buoyed asset prices across the board.

      What has yet to convincingly happen is for stocks to truly enter a bear market of their own. Right now we’re still in that half time show … the second half will be where stocks lose not only in dollar terms but against other assets (especially bonds and gold I suspect), which could well even gain in dollar terms. Very tentative at this point, but market action this week may be the first appearance of that second half kickoff.

      For that, you need more than a mere change in the value of the measuring unit; you need something unique to stocks apart from other asset classes. Earnings fit the bill.