The Fed’s Inflation Fighting Credibility Is Really On The Line This Year
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Francis, what is your view of inflation right now in the United States?
Francis: Well, the short answer for me is: the direction is down. I don’t think there’s a lot of dispute about that anymore. The real question is: are we going to 2% or are we going to hit 3% to 4%, and then level out? My view is we’re going to go to 2%, maybe even lower. As you know from a lot of the conversations we’ve had in the past about the outlook and this particular topic, our view has been shaped by the idea that this isn’t a normal business cycle. We’re living through the normalization of the economy following a disaster brought on by the pandemic, the lockdowns, and the various reactions to both. To recap briefly, we had the biggest bust in history. The authorities reacted to it with historic reflationary stimulus on a scale we’ve never seen before. As a result, we experienced the sequence of inflation rolling through asset markets. We had asset market inflation. Then we got commodity market inflation. We got real estate inflation, and ultimately, we got inflation in goods and services itself.
In late 2021, the Fed started to get nervous that inflation might not be transitory after all. They really started to get nervous when they saw this reflationary impulse roll into wage inflation. Then, they pivoted. They shifted the narrative from “it’s transitory” to “it’s structural.” And the shift really felt like they were panicking over the realization that they got it really wrong, and they needed to catch up in order to preserve the inflation credibility.
So, what’s happened since they made their pivot? It’s been a bit like watching a movie in reverse. In a word, we’ve seen a lot of deflation. Stock and bond prices have fallen, commodity prices have retreated, and real estate prices have started to decline. Additionally, in the second half of last year, price inflation retreated a lot. The data—looking at both headline and core CPI—is pretty convincing, indicating that the peak in inflation was mid-2022. It’s fallen a lot in the last six months, and likely to keep falling. It should fall all through this year. And my own view is it’s going to be 2% or less by year end.
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That’s very compelling, Francis, and it seems there are a number of market indicators that also suggest that inflation could be coming down. But the Fed doesn’t really seem to have that view. What’s going on?
Francis: It’s hard to tell what the Fed believes at times— especially after underestimating inflation so badly last year. The Fed’s inflation fighting credibility is really on the line this year. At the December Federal Open Market Committee (FOMC) meeting, what was really interesting was every single FOMC member believed that interest rates had to go higher this year, notwithstanding this declining inflation rate that I just mentioned that was playing out all through the second half of 2022. So, the Fed shifted its view on inflation from transitory to structural concerns almost at the peak of the price-inflation cycle in the middle of last year. Now, it’s really focusing on how tightness in the labor market and how sticky wage inflation might prop up service sector price inflation. However, we know from the yield curve that the market believes that in last year’s panicky effort to correct its wrong and get ahead of inflation that they overshot equilibrium. The yield curve’s inverted. It’s been that way for a while now. Even in the Fed’s own summary of economic projections, they have an equilibrium fed funds rate at 2.5%.
So, the market’s saying the central bank is overdoing it. Conditions are very restrictive. It’s not just the yield curve. If you look at the money supply, we’ve seen an unprecedented contraction, in nominal terms, in M2;8 and, the contraction in money supply in real terms is as severe as it was in the 1980s. These conditions are what the yield curve is picking up. Inflation’s not going up as long as money growth stays this weak. If you look at risk assets, risk assets have been rallying lately. Risk assets are finding optimism in the inflation developments. But because the Fed sees financial conditions as part of the transmission mechanism on inflation, Fed Chair Powell has kept up his sort of hawkish rhetoric. They reduced the pace with the 25-bps increase in February, but there’s still no discussion about the case for lower rates.
