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Weekly Inflation Outlook: Time To Be Wrong More Slowly

By Michael AshtonMarket OverviewJul 04, 2022 07:23AM ET
www.investing.com/analysis/weekly-inflation-outlook-time-to-be-wrong-more-slowly-200626637
Weekly Inflation Outlook: Time To Be Wrong More Slowly
By Michael Ashton   |  Jul 04, 2022 07:23AM ET
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This article was written exclusively for Investing.com

Chairman Powell was again on the tape this week, speaking at an ECB Forum in Sintra, Portugal. It must be nice to have such a plump travel budget even when you’re bad at your job. In Sintra, Powell produced this frameable gem:

“We’ve lived in that world where inflation was not a problem. I think we understand better how little we understand about inflation.”

If by “we” he means “the Fed”, then he’s right. Clearly, at least the people in charge at the Federal Reserve and at other major central banks have no earthly idea how inflation works. It is somewhat surprising that he would be so candid as to admit befuddlement, since we are always hearing about how important it is that investors and consumers have confidence in the Fed and how that really is the whole game.

However, on that latter point, the Chairman probably feels fairly confident at the moment. The story of this past week, really, was about the utter collapse in inflation expectations despite no evidence (outside of a mild slide in gasoline prices and a weakness in some other raw commodities) of slowing price increases. Ten-year inflation swaps fell 18bps on the week. Two-year inflation swaps dropped 40bps. And, remarkably, just like that the 1-year forward inflation curve shows that investors think this will all be behind us one year from now (see chart, source Bloomberg with Enduring Investments calculations).

Sport and 1-year Inflation
Sport and 1-year Inflation

The 1-year inflation swap dropped from 5.15% to 4.55%. This seems cavalier when median inflation is still rising, but there’s no accounting for short-term trading in inflation. But 1-year inflation, 1-year forward is at 2.75%, and after that, the curve is flat at around 2.25%. In other words, market pricing suggests the Fed will absolutely stick the landing, despite the Chairman stating that they really have no idea how inflation works.

And hey, if those curves are a fair reading of consumer inflation expectations, and inflation itself is anchored somehow to inflation expectations, then maybe we will get lucky and this plane will swoop gently to the runway despite the fact that the pilots are telling us they don’t know what they’re doing.

That’s charitable.

A different interpretation might be drawn. There are two reasons that a tug-of-war rope isn’t moving at any given point in time. One reason is that everyone agrees that the tug-of-war is pointless, so no one is pulling on it. The other possibility is that there are very strong forces on both sides, but they offset. Perhaps—and I have no way of evaluating if this is the true state of affairs—we just have two diametrically opposed camps and they are suddenly in balance.

On one side are the people (like myself) who think that the inflation rate will likely decline over the balance of this year and into 2023, but not get anywhere near the Fed’s target. On the other side are people who recognize that we are either in a recession right now, or will be in a recession sometime in the next year, and think that means inflation will rapidly drop back to normal or even threaten us with deflation.

The “recession” people have been getting plenty of data lately supporting their thesis with respect to growth, even if they haven’t been getting any data supporting the idea that prices will decelerate (or even decline). Home sales have abruptly weakened, manufacturing surveys and consumer confidence have been weakening at a sickening pace, and the Atlanta Fed GDP Nowcast on Friday fell to an estimate of -2.1% for the quarter we just finished.

Atlanta Fed GDP Estimate
Atlanta Fed GDP Estimate

Now, I’m in the camp that expects inflation to stay sticky and uncomfortable, but I have also been very clear that a recession is virtually guaranteed when you get rapidly increasing energy prices alongside rising interest rates.

How can I hold both views?

Well, because growth and inflation aren’t linked at the hip, and people who do understand a lot about inflation know that.

I know that people think that excess growth causes inflation. I know the models we were all taught in college and graduate school assume that is true. But here is the evidence. Quarterly observations from 1970, using the most-flattering lag of growth (real GDP) onto core inflation (Core CPI). The R-squared is 0.075. If you only look at 1970-1992, the R-squared shoots up to a nosebleed 0.121. Note that there are plenty of periods where growth was, say, 0.5% annualized or below, but core inflation was at or above 4%. In fact, the average core inflation for all such quarters of slow or negative growth was 3.5%. Hmmmm.

GDP Vs. Core CPI
GDP Vs. Core CPI

Taking a Step Back…

Let’s play a game called “What to do if you know that you don’t know how it works”.

Suppose you confront a big, complex machine. However, there are only two or three controls on it, and the one thing you know for sure is “we don’t know how this works”. The machine is running very fast, and it seems like it is overheating and you need to stop it. What’s your play?

If you really don’t know how it works, then doing something is as likely to worsen the situation as to make it better. But if you do nothing, then the machine will overheat!

What you really should do, probably, is ask someone who knows what they’re doing. But if such a person isn’t available, another reasonable approach would be to try something small, evaluate the effect, then do either more of that thing or less of that thing. If there is a dial, turn it a wee bit to the right, and then based on what happens, either turn it more to the right or reverse it to the left. What you would probably not want to do is rip the dial violently to one side, and to keep spinning it before you know what happens.

That’s what the Fed is doing, effectively. I noted recently that monetary policy currently is experimental because never before has the central bank attempted to restrain meaningful inflation with interest rates alone. It seems crazy to me that policymakers have chosen to drive with aggressive speed down an unknown road. I suppose what I am saying is that I don’t think the Fed really thinks that they don’t know. They may be saying “we don’t understand inflation” so that their past errors (“transitory”, e.g.) don’t seem as egregious – but they are behaving as if they are very confident in what they are doing.

If that’s the case, then what message do they draw from the last couple of weeks? Growth-related asset markets have dropped (8.5% stocks, 10.4% commodities), economic growth itself seems to be weakening, and inflation expectations (at least, market-based measures thereof) strongly signal that inflation is under control. Central bankers may conclude that these are signs that the inflation fight is nearer to being finished than they thought, and that they can therefore slow down and tighten more slowly. The interesting thing is that this is also the correct approach if policymakers recognize that they don’t really understand the machine, and so waiting to see what happens as the result from prior actions has some inherent value.

Either way, they are almost certainly wrong—the inflation fight is not close to being finished. But if they are going to be wrong anyway, it probably would be better if they were wrong slowly.

Weekly Inflation Outlook: Time To Be Wrong More Slowly
 

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Weekly Inflation Outlook: Time To Be Wrong More Slowly

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Comments (9)
Manfred Kruger
Manfred Kruger Jul 06, 2022 4:38AM ET
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Unfortunately they have been way behind on everything, buying mortgage backed securities in an overheated real estate market and now raising rates into a weakening economy. The FED should be abolished.
Jim Hernandez
Jim Hernandez Jul 04, 2022 11:50AM ET
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It's easy to criticize, I find myself doing this a lot and trying to do better. We should all be pointing fingers at ourselves for keeping inflation high. If we stop spending money on anything extra, prices will drop. Stop buying cars..stop going to the stores to shop for things you don't need right away. Stop buying houses and those ridiculous prices will drop. All this is in our power to do, but when everyone is working and has money, the emotion causes us to spend it. Stop and then watch what happens to prices. Don't wait for the Fed to force us to stop, do it on your own.
Peter ONeill
Peter ONeill Jul 04, 2022 11:50AM ET
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Pretty sure that's the worry though - people stop buying cars / houses / phones etc and then you enter a recession territory.
Angus Malarkey
Angus Malarkey Jul 04, 2022 11:50AM ET
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you don't understand inflation. there's too much money chasing too few things.
bert prince
bert prince Jul 04, 2022 11:50AM ET
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powell's fed deserve this critisism. This man WAITED to be reappointed before aknowledging inflation and moving rates
David Beckham
David Beckham Jul 04, 2022 11:50AM ET
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The only way to finish is until people has no extra money and bankrupt and store finally realize no one buy stuffs then they will lower price so simple it’s happened in Asia long time ago easy
Jim Hernandez
Jim Hernandez Jul 04, 2022 11:41AM ET
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All that to say the Fed doesn't know what they are doing? Give us some better stuff
Lucas Capaldi
Lucas Capaldi Jul 04, 2022 11:17AM ET
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Good article.
Chris Hall
Chris Hall Jul 04, 2022 11:17AM ET
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inflation... ya it stands at about 50% not 9% government lies its what it does
Art Carrano
Art Carrano Jul 04, 2022 11:12AM ET
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We live in a world where the Fed Chairman doesn't understand inflation and a supreme court justice doesn't know what a woman is.
Jul 04, 2022 11:12AM ET
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It is all just trans-itory!
Robert Dickison
Robert Dickison Jul 04, 2022 11:05AM ET
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Scary to have someone at the head of the Fed who makes such a statement. Duh oh
simone scelsa
simone scelsa Jul 04, 2022 9:14AM ET
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Inflation is a Hydra with many heads, they cannot do the same mistakes that were done in the 70s. Only a very resolute intervention from Volcker managed to finally calm inflation after several botched attempts by his predecessors.  The main problem is that there is no political will, long term, to stop an uncontrolled growth of the money supply.
Lalit Mohan Pandey
Lalit Mohan Pandey Jul 04, 2022 9:14AM ET
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Unless something substantial is done in solving Russian Ukraine issues, both recession and inflation will loom over the economic growth for more time to come.
Angus Malarkey
Angus Malarkey Jul 04, 2022 8:07AM ET
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WOW!!!Finally some straight talk!
 
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