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Good morning. I don’t think I can remember a major data release that came in as closely in line with expectations as yesterday’s CPI report. Calling around to economists and strategists yesterday, all of them struggled to name something in the report that didn’t fit with their own or consensus targets. Not sure what that signifies, if anything.
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As bad as we thought is plenty bad enough
Well, here we are:
The blue solid lines are core inflation, which excludes food and energy, compared with a year ago and with last month. The dotted green lines include all items. The annual rate of inflation is accelerating, for the third month in a row. Monthly increases are steady, with the interesting wrinkle that headline has fallen just below core, because food and energy prices both fell last month (a phenomenon most observers do not expect to last).
As expected, goods were the big driver. The egregious example remains used cars, which rose 37 per cent from the year before, handily beating the S&P 500. This confirms my plans to liquidate my 401k and retire on the proceeds from selling my 12-year-old Mazda, which at its current rate of appreciation will be worth $2.7m in 2041.
Shelter prices, which everyone is watching closely because of their link to wages and their tendency to persist, were hot, but not hotter: the monthly growth rate was in-line with the previous two months. But this data lags, and CPI rent will get higher before it gets lower. It currently reflects neither the huge spike in rents at mid-year or the cooling in rents we have seen very recently.
Earlier this week, I wrote that panic was merited when we saw sharp acceleration in services prices (outside of healthcare and transport). The reason for worry is that we have a good theory of why goods inflation might go away. The pandemic has pushed demand away from services towards goods; stimulus payments have meant total demand has not fallen, possibly even risen some; when the pandemic subsides, demand will shift back towards services, and goods prices will normalise.
But if strong demand and limited labour supply force wages higher, and those wage increases leak into services, that’s evidence we are heading for a big, sticky wage-price spiral.
Well, the wage-sensitive services I was warning about did accelerate in December, if not exactly sharply. Prices of everything from haircuts to house cleaning to legal services and funerals picked up from November, to greater or lesser degrees. These are volatile series, and we need more confirmation of this trend. But I do not like this one tiny little bit.
It is especially worrisome because real (post-inflation) wages are falling. Workers have good reason to respond to pervasive price increases by demanding more pay. Olivier Blanchard of the Peterson Institute put the problem this way in an email:
If I am a worker, I look at 2021, and I conclude I have lost quite a bit of real income (actually, based on my perception of the prices I see every day, I believe inflation has been substantially more than 7%). The labour market is tight; good time to ask for a wage increase, or threaten to quit, or if there is any kind of union, go on strike . . .
This is the wage price loop . . . This is where the uncertainty is. This is what may force the Fed to do even more than it is slowly promising to do.
It does not have to happen this way, as Blanchard acknowledged. As Don Rissmiller of Strategas put it to me, there is a wage-price spiral happening already in some low-wage areas such as leisure and hospitality. But:
There is still a way out, especially for the high-wage professions. People are asking for flexible work. They don’t want more pay, they want to work at home Monday and Friday . . . it’s one more pressure-release valve. Certainly there is the risk, and the biggest risk we’ve had in a while, that we are heading into some sort of wage-price cycle. But there is a chance that the Fed can act now and stop the services inflation.
How can you stop inflation with less-negative real rates?
The Fed projects, and the bond markets expect, that at the peak of this rising cycle the policy rate will be about 2 per cent, or a touch more. That means the Fed and the market think the central bank will halt inflation while never pushing real rates above zero.
This is a strange idea, on its face. Think of it this way. If all goes as expected, in a year short-term rates will be all of 1 per cent higher than they are now, and still very negative in real terms. How is that going to constrain the economy in any meaningful way? It seems a stretch to think such a small change would constrain either consumer or corporate spending significantly.
The range of views on this puzzle is remarkably wide.
Paul Ashworth of Capital Economics argued that “even the Fed easing its foot off the accelerator a bit” can actually make quite a large impact on the real economy. Not only are marginal decisions about whether or not to take on debt are affected, but a higher cost to borrow diverts resources away from other forms of spending. Given that the neutral rate of interest (the rate that would pervade if the economy were running at potential, with full employment and constant inflation) appears very low right now, small changes in rates can be significant, even if real rates stay negative.
(To be clear, Ashworth does not think that 200 basis points of increases will get inflation back to 2 per cent, but he thinks it will help).
My colleague Martin Wolf disagreed. As a mechanical matter, he thinks the policy won’t cool the economy to any significant degree. He says it all comes down to credibility:
The actions themselves don’t really matter. What matters instead is the confidence that the Fed is serious about its goals. Then, if what it has done is not enough, the Fed will do more — much more. So, the signal is the policy and the signal on its own might be enough . . . but that only works to the extent that the intentions revealed are believable. The smaller the credibility of its intentions, the more the Fed will need to do to show it’s serious …
For 40 years the Fed has lived on [Paul] Volcker’s credibility. Maybe it will have to show it means it once again. That would be a nightmare. And that is also why letting inflation rip is dangerous. The more that needs to be done, the less credible the needed actions become. That is why a Volcker became necessary in the 1970s.
Rissmiller takes still a third view. The endgame of a Fed tightening cycle is an inverted yield curve, which shakes confidence, which in turn can lead to tightening credit conditions:
And inverted curve is hard to deal with, if you assume the future is more uncertain the present. It hurts confidence, and the financial sectors’ ability to make profits . . . you at least get a situation where, with an inverted curve people will become concerned and take less risk . . . and then if the tide goes out a bit, someone [a big creditor] has a problem, and then credit spreads widen, and it all becomes self-reinforcing.
These views likely have a fair amount of overlap, and are not mutually exclusive. But the diversity of opinion about how monetary policy under low rates and inflation works is an unnerving fact that investors should keep in mind when trying to predict what happens next.
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