From Disinflation To Reflation

January CPI came in hot Tuesday at 0.5% month over month and 6.4% year over year. Many economists, including yours truly, prefer to focus on year over year changes because they eliminate messy seasonal adjustments. The tradeoff is that annual changes cover the last whole year and are therefore inherently more backward looking than monthly changes.

In this case, however, they’re in pretty good agreement. CPI growth has averaged 6.4% over the past year and about 6.2% over the last month annualized. The value of the monthly change is that it tells us that consumer inflation is reaccelerating. January’s figure was 0.5% compared to December’s figure of 0.1%.

Monthly figures can be noisy too. So last month’s PPI adds the value of helping to confirm or refute an acceleration. The verdict? Confirm. January’s figure came in hot Thursday at 0.7% compared to December’s figure of -0.2%.

None of this comes as a surprise to Financology readers. We explicitly said over a month ago that Inflation Is Back. Inflation did not return in 2023 though; it returned in the fourth quarter of 2022. At the risk of sounding like a broken record, inflation shows up in real time asset markets first, then passes into the pricing chain from there. After rising for the bulk of 2022, the dollar began to fall again late in the year, against a broad swath of assets, including foreign currencies, bonds, stocks, and commodities. It was inevitable then, that if that persisted, it was doomed to fall against goods and services.

It did persist and it did fall against goods and services.

Just as we predicted. Let’s not oversimplify though. The lags are multiple and variable. Some of the goods and services inflation we’re seeing now is the exhaust fumes of dollar depreciation that occurred a decade ago. Some of it a month ago. And everything in between. So for example the deflation that dominated most of 2022 was not promptly met by goods and services deflation, but rather a deceleration in the rate, that is, goods and services disinflation. And the renewed surge in inflation in last year’s fourth quarter put an end to that, turning goods and services disinflation to reflation.

Why is no mystery either. After hammering home the message that the Fed would not abandon its firm resolve before its final inflation target was in sight, it did exactly that. The minutes of the December meeting indicate it was worried that downshifting to a slower pace of rate hikes might prompt an “unwarranted easing of financial conditions”. It attempted to compensate for weaker action with stronger talk. It gambled and lost.

To turn Teddy Roosevelt on his head:
Speak bigly and carry a soft stick.

The biggest losers are of course the American people, beset with declining real incomes as the pace of price increases of goods and services outpaces even brisk wage gains. It’s perhaps unsurprising that Cleveland Fed president Loretta Mester “leans hawkish” given that her constituents are more representative of the average American than those of the prime beneficiaries of ultralow rates and inflation in Silicon Valley and on Wall Street. She said she saw a “compelling economic case” for a 50 bp hike at the last FOMC meeting and emphasized the the FOMC is not locked into a smaller hike next meeting. Similarly situated St. Louis Fed president James Bullard has advocated likewise. That their view will prevail seems a long shot given the outsized influence of the wealthy Silicon Valley and Wall Street constituencies, but markets have begun to price in the possibility of 50 bp hike in March.

Chairman Powell has backed himself into a tough spot, looking weak and suffering credibility loss after having so adamantly vowed to take the high road last year. All is not lost though … as we’ve noted before, even the current downsized pace of hikes might be sufficient if supplemented with firmer action in rolling off the balance sheet, particularly its massive hoard of MBS.

Regardless, Powell’s credibility turns on keeping “financial conditions” in the spotlight, as he did for most of last year. This had the benefit of sidestepping the problems of lags in the economy’s response to monetary policy. There are no lags between policy and financial conditions. They’re a real time indicator of just how easy or tight monetary policy is, and Powell was remarkably effective in using them, especially stock prices, to engineer goods and services disinflation in 2022. This had actually started to put a dent in the wealth gap as well. It remains to be seen just how Powell prioritizes the tension between the wealthy who benefit from inflation versus the majority who suffer.

If indeed Powell remains as committed to quelling final inflation as he appeared to be last year, and is unwilling to be flexible on the balance sheet, let’s hope he at least fully appreciates the tradeoff between how high rates must go and how fast they get there. The markets’ response to a mere shift to a slower pace of hikes – an easing of financial conditions – starkly demonstrates this. This is also evident in a tradeoff between short rates and long rates. Some writers express concern for example about the effect of higher rates on the federal budget. But we already see rising rates on long end of the yield curve as markets begin to price in more inflation. To mix metaphors, the drip drip drip of water torture is more painful than ripping the bandaid off quickly.

Another favor the Chairman could do for himself, his institution, and the American economy is to stop trying to be so effing predictable. This Greenspanian legacy of trying to telegraph to the markets what you’re going to do long before you do it is a form of ease itself. Reduced uncertainty is an invitation to speculate, so the more predictable policy is, the tighter it must be to achieve similar results. It also puts policy further behind the curve because of the additional lag between articulating and implementing it. Mere procedural dogma and market mollycoddling have put the Fed in a box from which it’s high time to break free.

Surprise the markets, Mr Powell. Say changes in balance sheet policy are on the table at every meeting. Let the Fed funds target be solely a function of the data available on the date of the decision. If financial conditions persist in easing, maybe even do an inter-meeting hike. Last year you channeled Tall Paul. Easy Al doesn’t look so good on you.

7 thoughts on “From Disinflation To Reflation

  1. Bill Terrell says:

    Let’s briefly consider the investment implications. Last year hot CPI data was good for cash. Once markets began to breathe easier about consumer inflation, cash suffered. Counterintuitive maybe, but the scarier the final inflation data, the greater the policy effort to address it.

    I have no reason to expect it to be different this time. The technical picture suggests a near term stock decline. A stronger dollar (cash) would extend this to other assets as well. We abandoned our cash overweight back in November, but nudging up cash again could make sense now. When final inflation data again turns more benign, less cash would again be appropriate.

    We can expect that to happen if financial conditions tighten again; specifically after a period of a stronger dollar and declining asset prices. It continues to be the case that the inflation “storage tanks” are full, and that asset prices cannot rise without consumer prices following suit. Whether what we’ve seen is sufficient or whether it will take further hot final inflation data to persuade markets and policymakers is the key near term issue. Richmond Fed president Tom Barkin, whose district includes Washington DC, for instance today spoke favor of the water torture path to inflation remediation.

    What to watch for? A quick and dirty indicator right now is VXUS. An attractive feature of this indicator is well over a decade of mean reversion. Below $50, stocks are an attractive long term investment; the further below, the more attractive.

  2. jk says:

    i’m beginning to think i was right with my wild guess that the fed might get to 6.

  3. Bill Terrell says:

    Aye, JK … it’s far from out of the question. Two other policy variables will determine how high the “terminal rate” is. One is balance sheet policy .., even the current target could conceivably be enough if the Fed cuts the balance sheet faster. That seems like a long shot.

    The other is how fast it hikes. The longer it takes to get there the higher it will have to go. Just look at the effect of cutting the pace of hikes on financial conditions, and how progress on CPI inflation stalled once asset prices started taking off again.

    Based on the correlations we’ve seen so far, another 20% off the stock averages could bring the Fed’s 2% target into view and obviate the need for further hikes.

    My worry is that the Fed is gravitating towards its pre-2008 mindset that if it tightens gradually and predictably, the markets and economy will respond gradually and predictably. Nice theory, but …

    … at 25 bp per meeting, it’s not hard to imagine Fed funds reaching 6% and triggering a full blown financial crisis.

  4. Bill Terrell says:

    The January personal consumption expenditures deflator was reported this morning at 0.6% higher than in December, an acceleration over the 0.4% increase the prior month. The increase was 5.4% over a year ago, also an increase from the 5.3% year over year increase reported for the prior month.

    These data further confirm the reflationary message of the earlier reported CPI & PPI.

  5. cb says:

    Hi Bill –
    Disinflation is inflation.
    Reflation is inflation.
    2% inflation is inflation.
    The FED has no intention to eliminate inflation.
    They are bastardizers of the dollar.
    and beneath contempt.

    1. Bill Terrell says:

      So true, CB. After 110 years of inflation, the value of the USD has been reduced to a fraction of a percent of its value. We are now reduced to hoping not for the elimination of the scourge, but for lower degrees of scourgeness.