Every time the Federal Reserve finds a new excuse for soaring inflation and why it will not continue, the data knocks it down.

Inflation was found to be transient and rather accelerated, reaching the largest increase in one month since January 1990. It is even higher relative to pre-epidemic prices, so what is happening now is no longer catching up with last spring’s deflation. It is no longer a matter of supply chains being disrupted because of the corona, or demand for used cars and other popular items. Even the Fed’s winning card, FAIT (Flexible Average Inflation Targeting), a variable average inflation target, has been eroded.

The only explanation left is that inflation will still be temporary – not passing as hoped, but disappearing spontaneously. Investors are still buying this story, but the risk is mounting that the Fed will have to act much more firmly.

Here are the excuses for inflation:

temporarily. For the first time since 1989, monthly inflation was above 2% for 12 consecutive months. Anyone who has built on the fact that inflation will be temporary and still thinks it will disappear by itself needs to think of some explanation.

Prices compared to prices before the plague. In the summer, Federal Reserve Chairman Jerome Powell stressed the declining prices of many products as demand fell during the epidemic and overall recovered recently. For those who were allowed and wanted to fly, airline fares were as cheap for a short time as in 1995, while home clothes used for work from home caused men’s suits and coats to fall to the lowest price ever recorded. Data on clothing prices have been recorded since 1978.

Many of these prices have not yet fully recovered. But the rise in prices of other things since Powell talked about these points has further offset these price declines, and the annual rate of inflation for all items since February 2020 is over 4%.

Epidemic-related problems. Powell pointed out that price increases were limited to a limited range of items for which demand soared and supply chains were limited. He highlighted sustainable goods, with new car prices higher than ever – and said used car prices appeared to have stabilized. Relief was short-lived and prices of used cars and other durable goods rose again in October. Non-durable goods joined this and increased at an annual rate of 4.7% compared to the days before the plague. The price of a median product in the consumer price index basket is also rising rapidly.

Another way to see this is to eliminate the prices that go up and down the most. The Cleveland Federal Reserve says that without the 16% highest and lowest in products, the monthly increase in October was still the highest since it began listing in 1983. Powell prefers a different measurement from the Dallas Federal Reserve, which exceeds the highest-rising prices compared to those that rise slightly, but even in such a calculation inflation rises and should be even higher once all October figures are published.

It may be that supply chain disruptions have spread to other areas, thanks to the beginning and cessant nature of closures around the world, so price pressures will subside when the world economy finally returns to normal. But it is also not unreasonable to think that something has changed substantially in the way we accept the higher prices and also in the desire of companies to pass on the large increase in inputs related to wages and other costs involved in operations.

FAIT. Last year the Fed introduced a policy of compensating for inflation below 2% by allowing it to be high from time to time as well, and defined the policy as an average desirable inflation target. I think it’s hard to justify it, but even if you accept the premise, the road to this approach will soon end. There is no official period in which the average is supposed to be measured, but consumer prices have now risen by exactly 2% on an annual basis compared to the 2% target first introduced in 2012. In other words: the whole horrible period of the “new normal” of disinflation that was before the plague was erased by a little over a year of price increases.

The Federal Reserve still has little way to do with FAIT because the calculation uses the private consumer spending index to measure prices, which is lower than the consumer price dimension. If the private spending index rises by leaps and bounds in the October consumer price index over the next three months, the Fed will be exactly on target of 2% since 2012. Of course, the word flexible is there because the Fed does not want to be locked into something so it can act as it pleases. .

Transient. Eliminate all excuses, and what is left is hope: the hope that inflation will go away on its own. The very high October figures persuaded traders to bet on rising interest rates earlier than in the past, and futures on Fed funds are betting on a one in five chance of two or more interest rate hikes by next June. But while investors expect the Fed to react a little earlier, in the long run they are optimistic about both inflation and rates, and expect the pressures to dissipate on their own.

When pricing the inflation rate in the bond market for the five years that begin in another five years it is slightly higher, but stands at 2.3% (relative to the index), so the Fed is meeting its target. This is reasonable enough for anyone who trusts that the Fed will eventually take action against rampant inflation.

What is surprising is that investors do not really expect any such action either. The real yields on inflation-protected bonds from the Ministry of Finance is at the lowest level ever or close to it. If investors were to think that real rates were going to have to go up, yields on such inflation-protected bonds were supposed to go up a lot, and that did not happen.

There are two big mistakes the Fed may make. First, the Fed may be wrong that inflation is passing, because both consumers and businesses seem more willing to absorb high inflation. This creates a self-fulfilling dizziness of wages and prices, to the extent that such a thing seems unreasonable. In such a situation, the Fed will have to take drastic measures because it has waited too long to act, and will have to raise interest rates quickly and hit the economy and property prices, as happened in many interest rate circles in the second half of the 20th century.

The second mistake is that the Fed is right, but concludes that it is wrong. There is no science involved in measuring inflation expectations (surveys show all the possibilities and the bond market is notoriously unreliable) so the Fed may easily fear that people believe inflation will stay, but make a mistake about it. So it may raise interest rates quickly, and shock an economy that was already in the process of cooling down anyway.

Navigating between these two messy results is not easy, but for now at least, investors still believe the Fed will do it more or less correctly.

By Editor

Leave a Reply