Inflation Complacency
Doug Nolan
Some headlines from the week:
“Fed Officials Signal Slower Pace of Rate Hikes.”
“Top Fed Officials Foreshadow Further Slowdown in Rate Increases.”
“Fed’s Brainard Lends Support to Slowing Pace of Interest-Rate Rises.”
“Fed’s Waller Backs Slowing the Next Rate Hike to 25 Basis Points.”
“Fed’s George Says a Soft Landing Still Possible for US Economy.”
“Fed’s Brainard: Taming Inflation May Not Cause Big Job Cuts.”
“Fed Governor Waller Says Looking Forward, Rates Are Restrictive, Pretty Close to Sufficiently Restrictive.”
“US Can Slow Inflation Without Unemployment Spike, Fed Study Says.”
“Boston Fed’s Susan Collins Says Measured Approach to Rate Rises Makes Sense.”
Dow Jones quoted Boston Fed president Susan Collins:
“Now that rates are in restrictive territory and we may, based on current indicators, be nearing the peak, I believe it is appropriate to have shifted from the initial expeditious pace of tightening to a slower pace.”
Are rates sufficiently “in restrictive territory” considering the past year’s inflationary surge?
December’s 3.5% unemployment rate was the lowest since 1969.
Clearly, the Fed’s tightening cycle has yet to make crucial headway in cooling hot labor markets.
And as 2023 gets underway, markets are behaving as if monetary policy is invitingly unrestrictive.
January 19 – Bloomberg (Finbarr Flynn, Garfield Reynolds, Ronan Martin and Josyana Joshua):
“The best start to a year for bond returns is helping fuel an unprecedented debt-sale bonanza by governments and companies around the world of more than half a trillion dollars.
From European banks to Asian corporates and developing-nation sovereigns, virtually every corner of the new issue market is booming, thanks in part to a rally that’s seen global bonds of all stripes surge 4.1% to start the year, the best performance in data stretching back to 1999…
Excess demand for offerings, falling new issue concessions and the largest inflows into high-grade US credit in more than 17 months has helped make this year’s January borrowing so far the busiest ever.
Global issuance of investment- and speculative-grade government and corporate bonds across currencies reached $586 billion through Jan. 18, the biggest tally on record for the period…”
Despite all the talk, previous and ongoing, this Federal Reserve is soft on inflation.
Not as eager as Wall Street to declare mission accomplished, Fed officials are nonetheless signaling that their work is near completion.
It’s worth recalling Fed thinking from one year ago this week (Barron’s Randall W. Forsyth):
“An array of Fed speakers basically confirmed widespread market expectations of three one-quarter-percentage-point increases in the federal-funds target from the current 0% to 0.25% range this year.
By week’s end, the fed-funds futures market was putting about a 60% probability of a fourth hike by December…”
The Fed began 2022 carelessly complacent.
And after a flurry of second-half 75 bps rate hikes - and a 4.25% Fed funds rate – easygoing Fed officials believe it’s nearing time to relax.
There’s a sense of satisfaction for executing an aggressive tightening cycle.
It may have gotten off to a slow start, but there’s now almost universal agreement that they adeptly and successfully played catch-up.
No harm, no foul.
But there have been major and ongoing executional issues that can’t simply be swept under the rug.
Fed funds were not taken above 2% until late July, a delay that ensured a year of exceptionally strong lending and Credit growth.
This granted inflation dynamics crucial months to become more deeply rooted.
A year ago, the Fed’s published longer-run “neutral rate” was 2.5%.
Neutral Rate:
“The neutral rate is the theoretical federal funds rate at which the stance of Federal Reserve monetary policy is neither accommodative nor restrictive.
It is the short-term real interest rate consistent with the economy maintaining full employment with associated price stability.”
What a distraction.
How much brainpower did the Federal Reserve and economics community waste debating “r-star” – the theoretical “neutral rate”.
Last year it was supposed to be 2.5%, and now this year it’s clearly much higher.
Fed officials should today be especially humble and prudent.
They whiffed on “transitory,” and the “r-star” neutral rate framework has proved worthless.
As a reminder, year-over-year CPI was 9.1% in June, and was still 8.2% not that long ago in September.
CPI has been at least 5% for 20 straight months.
Powell’s comments from November:
“There’s no sense that inflation is coming down…” “Rates have to go higher and stay higher for longer.” “Here in the United States, we have a strong economy…”
It’s too soon to signal waning hawkish resolve.
The FOMC during their February 1st meeting may decide a 25 bps rate hike is appropriate.
But why would they want to signal a small rate increase in advance?
The Fed might be approaching a level it believes is an appropriate “terminal rate.”
Yet central banker prudence and inflation-fighting resolve should err on the side of not conveying a rapidly concluding tightening cycle.
Especially with the markets demonstrating speculative impulses and loose conditions, Fed officials should be prepared to douse fires rather than fan them.
At least “lean against the wind.”
The Philadelphia Semiconductor (SOX) index enjoys a y-t-d (14 sessions) gain of 10.37%, the NYSE TMT Index 8.76%, the Philadelphia Oil Services Index 8.60%, the Nasdaq Transports 8.50%, and the Nasdaq Computer Index 6.97%.
The broader market is outperforming, with the small cap Russell 2000 up 6.02% and the S&P 400 Mid-Cap Index gaining 5.27%.
The “average stock” Value Line Arithmetic Index has jumped 6.65% to begin the year.
The Nasdaq100 has advanced 6.21%, while the S&P500 has gained 3.47%.
Indicative of the speculative nature of trading to begin 2023, the Goldman Sachs Most Short Index has sprinted to a 13.9% three-week gain.
“Risk on” is not limited to U.S. equities.
The iShares Investment-Grade Bond ETF (LQD) has already returned 4.86%, while the iShares High Yield Bond ETF (HYG) has returned 3.45%. The iShares Treasury Bond ETF (TLT) has returned 6.67%.
Major equities indexes have y-t-d gains of at least 8% in France, Germany, Spain, Italy, Sweden, Ireland, and Netherlands.
Hong’s Kong’s Hang Seng index is up 11.44%, China’s CSI 300 8.00%, the South Korean KOSPI 7.10%, and Taiwan’s TAIEX 5.62%.
Major indices are up 6.81% in New Zealand, 5.87% in Australia, 5.77% in Canada, and 11.3% in Mexico.
And with all the talk of peak inflation, it’s curious that gold has gained $102, or 5.6%, to begin the new year.
Copper is up 11.6%, Aluminum 8.8%, Zinc 16.3%, and Tin 16.1%.
Gasoline futures surged 4.4% this week to a two-month high.
January 19 – Bloomberg (Philip Aldrick):
“Going soft on inflation will plunge economies back into the recessionary depths of the 1970s and have ‘adverse effect on working people everywhere,’ former US Treasury Secretary Larry Summers warned.
The remark is a response to suggestions from economists including Olivier Blanchard, a former International Monetary Fund chief economist, who have suggested lifting inflation targets from 2% to 3% to avoid recessions.
‘To suppose that some kind of relenting on an inflation target will be a salvation would be a costly error, it would ultimately have adverse effect as it did in a spectacular way during the 1970s,’ Summers… told a panel at the World Economic Forum’s annual meeting…”
“Going soft on inflation” actually gained momentum with the Bank of England’s late-September emergency operations.
I understand why the BOE believed they had to restart QE to thwart bond market meltdown.
And I further appreciate that they made the program temporary, in hopes of guarding against moral hazard.
But the whole world was watching – and they saw exactly what they were hoping to see.
Following the bond scare and urgent BOE response, markets were assured that central bankers might talk tough on inflation, but they would not risk tightening to the point of sparking crisis.
Financial conditions almost immediately began to loosen globally, a loosening that has gathered important momentum early in 2023.
Loose conditions created a lot of dry tinder for a powerful cross-asset short squeeze that has only engendered looser conditions.
It was important that central bankers pushed back against the view that QE liquidity backstops would be restarted as necessary to quash incipient market instability.
Powell was hawkish during his November 1st post-meeting press conference.
But Fed hawkish resolve soon dissipated.
Now, messaging has become so frayed that markets don’t take hawkish resolve seriously.
The paramount message that the Fed would push back against looser market conditions is MIA.
I cherry picked headlines for the opening paragraph.
There were hawkish comments this week from key officials.
Brainard: “Inflation remains high, and policy will need to be sufficiently restrictive for some time…”
Williams: “With inflation still high and indications of continued supply-demand imbalances, it is clear that monetary policy still has more work to do…”
And Bullard stated his desire to get rates above 5% “as quickly as we can.”
But when conditions are loose and markets chipper, dovish comments resonate, while hawkish ones are easily dismissed.
Markets are pricing in a (near) “terminal rate” 4.89% for the FOMC’s May 3rd meeting.
Rates are then expected to reverse lower to 4.42% at the December 13th meeting.
Markets are not aligned with the Fed.
Early-2023 market policy rate expectations shouldn’t be as far off the mark as last year.
But could they be off by over 100 bps – with a year-end Fed funds rate of 5.5% or higher?
I see a number of developments that can work to push policy rates higher-than-expected.
The Bank of England’s confirmation of central bank liquidity backstops and resulting loosening was surely good for at least 100 bps of additional tightening.
That the Fed didn’t push back against loosening financial conditions during Q4 will require higher rates.
And the big short squeeze and speculative start to 2023 throughout global markets is definitely positive for the type of ongoing Credit growth that underpins inflation.
If highly speculative markets go on a run here, the Fed may have significantly more work to do.
And if Beijing is as desperate and determined as I suspect, there is potential for an astonishing year of Chinese stimulus and Credit growth.
There are clearly reasonable odds for surprises in both inflation and Fed hikes.
But market focus is elsewhere.
I explained last week the thesis that rates markets are pricing in probabilities of an accident.
January 18 – Reuters (Naomi Rovnick, Yoruk Bahceli and Dhara Ranasinghe):
“A seismic policy shift by Japan's central bank is still a matter of when not if, say investors now hunkering down for fresh havoc in bond markets and wild swings in currencies.
The Bank of Japan on Wednesday maintained ultra-low interest rates, including a bond yield cap it was struggling to defend, defying market expectations it would phase out its massive stimulus programme in the wake of rising inflationary pressure.
Analysts say a policy change is inevitable at some point given that Japanese inflation is at 41-year highs and the cost of keeping borrowing costs down rises.
‘Although the timing is uncertain, we are not changing our view, this is something that has to happen at some point,’ said Cosimo Marasciulo, head of fixed income absolute return at Amundi, Europe's largest fund manager.”
January 19 – Bloomberg (Ruth Carson):
“Global funds will pressure the Bank of Japan until it capitulates and tightens policy, after the central bank disappointed bond bears by refusing to lift its ceiling on sovereign yields.
UBS Asset Management and Schroders Plc are sticking with bets Japanese government bond yields will rise on the expectation the BOJ will eventually stop capping the 10-year benchmark at 0.5%...
Torica Capital Pty also expects the central bank to fall in line and shift toward the global trend of raising rates.
‘We see no reason to square up shorts,’ said Tom Nash, a money manager at UBS…
‘The yield-curve-control policy is not consistent with the current economic and political landscape and will need to be dismantled.’”
It was fascinating to watch the global market reaction to Wednesday’s (Tuesday night in the U.S.) Bank of Japan policy (non)announcement.
To see such volatility in JGB yields, the yen, global currencies, Treasuries and global bonds was evidence of the major role loose Japanese finance has played in global markets.
Kuroda needed to begin normalization – to release some steam – prior to his term concluding at the end of March.
The odds of a major accident are rising.
While ahead of the BOJ, ECB policy normalization is in the early phase.
Signals out of the ECB this week were alarmingly inconsistent.
Tuesday (Bloomberg):
“European Central Bank policymakers are starting to consider a slower pace of interest-rate hikes than President Christine Lagarde indicated in December, according to officials with knowledge…”
Thursday (Bloomberg):
“European Central Bank Governing Council member Klaas Knot said there’ll still be more than one half-point increase in interest rates…”
And Friday (WSJ):
“China’s abandonment of its zero-Covid policy is good news for global economic growth…
‘That is positive for the rest of the world, but there will be more inflationary pressure.’”
European bonds were hit Friday.
And when contemplating Treasury market pricing for an accident, China is a major 2023 risk.
Systemic risk is rising exponentially in China.
Credit continues to expand swiftly, while the quality of loans and finance deteriorates.
Massive stimulus raises the odds of currency instability. Something is going to break.
There is also the “Fed raises until something breaks” thesis that likely resonates within segments of the Treasury market.
With conditions loose and markets strong, it’s only natural for louder Wall Street warnings of Fed “overtightening”.
These are highly speculative markets, and the more speculative they become, the more difficult it will be for the Fed to tighten conditions.
I today equate such loose conditions with ongoing strong Credit growth and persistent inflation.
All the talk of Goldilocks and soft-landings is wishful thinking.
It would be a huge mistake for the Fed to relax with conditions this loose.
It’s reasonable to assume that inflation has peaked – for this short-term cycle.
But inflationary forces have been unleashed.
There are now powerful inflationary dynamics lurking throughout the system – at home and globally.
Companies have grown comfortable raising prices.
Labor has gained confidence to demand more compensation.
Global commodities supplies are tight.
And, importantly, policymakers must anticipate ongoing supply shocks.
Global fragmentation will gain further momentum, with negative ramifications for pricing pressures.
We should assume climate change will create significant risks to foods supplies globally, while boosting myriad inflationary risks.
And there has to be planning for inflationary consequences related to geopolitical developments.
An increasingly hostile world increases the likelihood of supply disruptions, certainly including energy markets.
If the Fed and global central bankers relax with inflation in the five to six percent range, it will likely spike back toward double-digits during the next inflationary shock.
This is no time for Inflation Complacency.
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