GETTING INFLATION DOWN MEANS HIGHER RATES TO COME
Its Only Just Begun
According to history, today’s discounting of the necessary monetary tightening to bring inflation down is inadequate. The terminal nominal Fed Funds rate is priced at about 3.5% by the spring of next year, and this is likely about 50 basis points below the 4% or so rate of core inflation we forecast early next year.
Experience suggests this is insufficient to bring inflation back to the 2% target; we would expect a real rate of at least 100 bps to have any hope of containing the current inflation trend. At no point in the past has a disinflation occurred with the overnight rate of interest this far below the current all-items rate of 9.1%, and a core rate of 5.9% the latter being the better predictor of future inflation. In fact, inflation tends to accelerate.
Inflation got here in the first place because of excessive support for income during the pandemic lock-down. Demand for social consumption – travel restaurants and lodging – collapsed and authorities increased fiscal transfers to limit hardship partly funded with new central bank money.
Money financing had a direct link between central bank money and peoples’ chequing accounts, yet consumption and production of services fell. With incomes intact, demand destined for vacations and restaurant meals was directed instead to scarce goods, with too much money chasing too few goods. Even children know this story of how inflation comes. Cost pressures that initially emerged from excess money creation were exacerbated by Russia’s invasion of Ukraine, taking food and energy prices even higher.
The direct link between the central bank and personal income has long gone, but its effect on inflation is still felt as the pandemic’s echo continues to sound. Inflation has momentum and is now subject to a second force: extremely tight labour markets. Vacancy rates have soared above available labour supply, leading employers to bid-up wages up to attract employees. While this relative price signal may be necessary to nurture service sector recovery, economy-wide excess demand has turbo-charged wages. The first-round impact has now been passed-through to wages: the wage price spiral is off to the races.
This brings us to the third and final potential force on inflation – and a worrying one – rising inflation expectations. The direct expectations channel that links wages to inflation can defy the downward pressure on inflation from excess supply for some time. Once unleashed, high inflation expectations require a severe downturn and a prolonged period of excess supply to purge as Canada experienced in the early and mid 1990s. Once unleashed, high inflation expectations make disinflation costly. We must hope the expectational wind is tempered before it becomes a gale.
Consumer price expectations are elevated reflecting recent experience, but investors continue to bet – even if nervously – that the 2.0% inflation contract with the central bank is intact. After all, investors have “contracted-out” management of inflation to the central bank and have imbedded 2.0% inflation into their investment return expectations. They are unsure whether they must reprice assets to allow for a permanently higher average inflation rate. To date they have not acted on that concern.
The Fed has a dual mandate: to maximize employment and minimize inflation but in times of high inflation these goals demand a choice as both cannot be achieved simultaneously. The Fed has one instrument – the Fed Funds rate – and at the moment it should target one variable: inflation. However, the Fed often attempts to chart a middle-way to meeting its inflation target while sheltering as many jobs as it can. This often leads to an inadequate tightening in interest rates, one that ultimately means more pain for longer to get inflation back to target. Other central banks have only inflation as their target and can ram-through a short sharp shock to get inflation back to target with less long-run pain. The pre-Euro German Bundesbank followed this approach as does today’s Bank of Canada.
Contrast the yield curves of the US and Canada where the recent 100 bps increase in Canada’s overnight rate has anchored the long end of the curve impressively compared to the 75 bps increase in the US. History shows the more bitter the medicine taken early in the infection, the quicker the disease is cured.
Two Negative Quarters Does Not a Recession Make
Inflation is not going to come down on its own; it must be managed down. Central banks own this responsibility and must do what they have contracted to do: bring inflation back to the 2.0% target. Central banks cannot affect the economy’s supply, but they can affect demand so they must bring the level of demand below the level of supply to open-up a disinflationary output gap. A policy-induced recession is likely necessary to dis-inflate successfully.
Outside of labour markets, there are signs that perhaps policy tightening to date is already beginning to bite. Inventories are being run down, mood indicators such as purchasing managers indexes are falling and production indicators are topping out. The market has seized on this as a comforting sign that excess supply is already on the way and that central banks can get back to the business of tending to growth and force-feeding asset prices. Wouldn’t that be nice?
More likely is the following, as the chart on page 3 shows. The sectoral shock to demand and the ensuing to-and-fro between services and goods demand saw a huge swing up in inventories and trade, and then a decline as retailers’ ability to forecast demand and optimal inventory levels was upended by the volatility.
Goods inventories were far too big as demand swung back to services. This demand-inventory imbalance has fed through to net trade as imports fell. While this looks like the stylized dynamics of early recession there is an alternative explanation. The dip in GDP reflects the last throes of the pandemic disruption as the system rights itself.
Now, it is so that when interest rates rise there is a lag of about 9 to 12 months to demand and about 24 months to inflation. The countdown to a slowdown is natural as central banks tighten, but it seems far too soon for the impact to be apparent: the monetary-induced slowdown is not likely to bite before December 2022 so it’s too early to conclude recession is here.
Follow the Output Gap and Monitor Expectations
The central bank model of the economic forces that shape inflation is simple: the balance of excess demand or supply combined with inflation expectations. Bringing demand below supply potential will in the end deliver inflation to target. Yet, Mervyn King observes, this model didn’t forecast inflation well in 2020/21. He identifies the direct gift of central bank money without the backing of production as a better explanation. But simply turning off the money tap doesn’t mean inflation will just go away. We need some model guidance to reverse inflation.
The output gap plus inflation expectations has been validated as the right management framework for reducing inflation and gives investors a useful monitoring structure to judge when inflation and then interest rates will peak and/or decline. Applying this structure allows us to monitor how much excess supply is opening-up and whether inflation expectations are contained to make our call. Prices can tell us a lot about the output gap and inflation expectations, as they are more timely than demand and production indicators. It often takes a year or more for the NBER to date the recession, and we can’t observe potential output.
The Atlanta Fed constructs flexible and sticky price indexes, where flexible prices are correlated with the output gap and sticky prices are correlated with inflation expectations. And this approach is helpful. Flexible prices are reset sometimes in a matter of weeks to reflect current conditions the cost of price changes is small. Sticky prices are generally only changed every 4 months or so because these prices have higher adjustment costs. The flexible price index reflects today’s demand-supply pressures, and sticky prices are a good predictor of inflation in two years time.
The current news from these two indexes is not good. These two indexes tell us that the US economy remains in excess demand and inflation expectations are both well above 2.0% and trending higher. While a small downtick in unrelated production and the purchasing manager mood indicators is apparent, it is not likely that excess supply has opened-up fast enough to validate the current market pricing of Fed interest rate increases. Moreover, financial conditions have not tightened at all over the balance of this year neutralizing much of the Fed’s ability to influence the economy.
What Does it Mean?
The current level of financial conditions should not give the Fed any comfort that it is close to constraining inflation. For investors, Vanguard founder Jack Bogel observed that equity earnings from companies reflected earnings growth and dividends which they could reliably predict. What is more difficult for investors to predict is what the market will pay for those earnings or the PE ratio. He argued the PE ratio was driven by expectations that are prone to overshooting and even that they are random. Market timing adds little to returns over time because we can’t reliably forecast changes in equity multiples.
The dividend discount model allows us to quantify what is at risk from PE ratios, not when they might change. When PE’s are high, risk of loss is high and when PE’s are low risk of loss is low. We know that equities don’t like double digit inflation and today we are at a crossroads: to validate today’s S&P500 level of 4136, inflation needs to fall to 1% or if inflation remains at 9% then PE’s need to fall by about 30%.
We can’t forecast equities with confidence, but we feel more able to forecast inflation: we see core inflation stabilizing at 4% in the spring of next year. But inflation will not fall to 2.0% on its own, and central banks have more heavy lifting to do.
The risk of loss remains elevated and risk assets are vulnerable to rising interest rates.
So far in 2022, and despite market volatility, financial conditions are unchanged even as core inflation surprises on the upside -- rising 1.9% in the past three months alone! Short of a bolt from the blue to zap demand, monetary tightening is far from over and risk of loss remains high.
Everyone should expect the recent swift and aggressive interest rate increases to continue until central banks get to an interest rate level that history suggests gives them confidence that inflation will eventually fall.
We are not there yet.
DISCLAIMER
The information included in this letter is believed to be accurate and complete, and comes from sources that we believe to be reliable. Spence Strategic Consulting Group Inc. makes no warranty as to accuracy or completeness of information or data.
Contents of this letter are neither intended to be nor constitute investment advice.
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Published by Spence Strategic Consulting Group Inc, 22 St. Clair E, Suite 1502, Toronto, Ontario. M4T 2S5.