Mon. Jan 24th, 2022


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Good morning. I do not think I can remember a major data release that came as closely in line with expectations as yesterday’s CPI report. While calling economists and strategists yesterday, everyone struggled to name something in the report that did not fit their own or consensus targets. Not sure what that means, if anything.

Send me an email: robert.armstrong@ft.com

As bad as we thought was very bad enough

Well, here we are:

The blue solid lines are core inflation, which excludes food and energy, compared to a year ago and with last month. The green dotted lines include all items. The annual inflation rate accelerates, for the third month in a row. Monthly rises are steady, with the interesting ripple that headline fell just below the core, as food and energy prices both fell last month (a phenomenon most observers do not expect to like).

As expected, goods were the big driver. The appalling example remains used cars, which have risen by 37 percent from the year before, beating the S&P 500 handy. This confirms my plans to liquidate my 401k and retire on the proceeds of the sale of my 12-year-old Mazda, which at its current rate of appreciation will be worth $ 2.7 million in 2041.

Shelter prices, which everyone is keeping a close eye on because of their relationship with wages and their tendency to persevere, were warm but not warmer: the monthly growth rate was in line with the previous two months. But this data slows down, and CPI rents will rise before falling. It does not currently reflect the large increase in rents by the middle of the year or the cooling in rents that we have seen very recently.

Earlier this week I wrote this panic was earnings when we saw sharp acceleration in service prices (excluding healthcare and transport). The reason for concern is that we have a good theory of why commodity inflation may disappear. The pandemic has pushed demand away from services to goods; stimulus payments meant that total demand did not fall, possibly even some rose; when the pandemic subsides, demand will shift back to services, and commodity prices will normalize.

But if strong demand and limited labor supply force wages higher, and those wage increases leak into services, it’s proof that we’re heading for a big, tough wage price spiral.

Well, the wage-sensitive services I warned about did accelerate in December, if not exactly sharply. Prices of everything from haircuts to house cleaning to legal services and funerals rose from November to more or less degrees. These are volatile series, and we need more confirmation of this trend. But I do not like this one little bit.

This is particularly worrying because real (post-inflationary) wages are falling. Workers have good reason to respond to penetrating price increases by demanding more pay. Olivier Blanchard of the Peterson Institute put the problem in an email:

If I’m a worker, I’m looking at 2021, and I’m concluding that I’ve lost quite a few real incomes (actually, based on my perception of the prices I see every day, I believe inflation was significantly more as 7%). The labor market is tight; good time to ask for a wage increase, or threaten to quit, or if there is any kind of union, start striking. . .

This is the wage price loop. . . This is where the uncertainty is. This is what could force the Fed to do even more than it is slowly promising to do.

That does not have to be the case, as Blanchard acknowledged. As Don Rissmiller of Strategas put it to me, there is already a wage price spiral happening in some low wage areas such as leisure and hospitality. But:

There is another way out, especially for the high-wage professions. People are asking for flexible work. They do not want payment anymore, they want to work from home on Mondays and Fridays. . . it’s another pressure relief valve. There is definitely the risk, and the biggest risk we’ve had in a while, that we’re heading for some kind of wage-price cycle. But there is a chance that the Fed can act now and stop services inflation.

How can you stop inflation with less negative real rates?

The Fed is projected, and the bond markets expect, that the policy rate at the peak of this upturn will be around 2 percent, or a touch more. This means the Fed and the market think the central bank will stop inflation, while real rates will never push above zero.

It’s a strange idea, on his face. Think of it that way. If everything goes as expected, short-term rates over a year will all be 1 percent higher than it is now, and still very negative in real terms. How is this going to limit the economy in any meaningful way? It seems for a while to think that such a small change will significantly limit either consumer or corporate spending.

The range of views on this puzzle is remarkably wide.

Paul Ashworth of Capital Economics argued that “even the Fed to loosen its foot off the accelerator a bit” could actually make a pretty big impact on the real economy. Not only are marginal decisions on whether or not to incur debt affected, but a higher cost of borrowing leads resources away from other forms of spending. Given that the neutral interest rate (the rate that would permeate if the economy were running at potential, with full employment and constant inflation) currently looks very low, small changes in rates can be significant, even if real rates remain negative.

(To be clear, Ashworth does not think that 200 basis points of increases will bring inflation back to 2 percent, but he thinks it will help).

My colleague Martin Wolf did not agree. As a mechanical matter, he believes that the policy will not cool the economy to any appreciable extent. He says it all comes down to credibility:

The action itself does not really matter. What matters more is the confidence that the Fed is serious about its goals. Then, if what he did is not enough, the Fed will do more – much more. So, the signal is the policy and the signal on its own may be enough. . . but it works only to the extent that the intentions revealed are credible. The smaller the credibility of its intentions, the more the Fed will have to do to show that it is serious …

For 40 years the Fed has survived [Paul] Volcker’s credibility. Maybe it will have to show it means it again. It would be a nightmare. And that’s also why it’s dangerous to let inflation tear. The more this has to be done, the less credible the necessary action becomes. Therefore, a Volcker became necessary in the 1970s.

Rissmiller still has a third view. The end game of a Fed tightening cycle is a reverse yield curve, which shakes confidence, which in turn can lead to stricter credit conditions:

And reverse curve is difficult to deal with, if you assume the future is more uncertain the present. It undermines confidence, and the financial sector’s ability to make a profit. . . you at least get a situation where people with a reverse curve will worry and take less risk. . . and then when the tide goes out a bit, someone [a big creditor] has a problem, and then increases credit spreads, and it all becomes self-reinforcing.

These views probably have a fair amount of overlap and do not exclude each other. But the diversity of opinions on how monetary policy works under low rates and inflation is a disturbing fact that investors should keep in mind when trying to predict what will happen next.

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