The Fed’s Not Out of the Inflation Woods Yet (Despite What Everyone Says…)

Summary

• Many think inflation is subsiding, but falling energy prices are masking strong inflation trends.
• The Fed hiked 50bp at this week’s meeting but Powell rebuffed the idea of raising the Fed’s 2% inflation target.
• Though on balance the meeting was hawkish, it shows the Fed is likely to react to higher inflation prints rather than trying to pre-empt them.

Market Implications

• The market is underpricing the peak and end-2023 federal funds rate. 
• Market pricing of the February meeting at 30bp is below my expectations of 50bp.

Falling Energy Prices Hide Strong Inflation Trends

What an unpleasant surprise, especially at 5:30 am (I live in Los Angeles). US inflation data came out on Tuesday, and core MoM CPI was 0.2% against consensus of 0.3% and my expectations of 40-50bps. It was another blow to my already UOOC (Utterly Out of Consensus) Fed view, which anticipates hiking to an 8% peak in the face of persistent inflationary headwinds.

Besides reaching out for some chocolate, I tend to react to challenging surprises through more data crunching. This is what I did, and here is what I found.

The recent slowdown in core inflation has been largely driven by the decline in energy prices (Chart 1). The impact is more obvious on core goods than core services. But even core services inflation is slowing, especially when it comes to transportation, which is very sensitive to energy prices (obviously!). Transportation prices fell MoM in November. 

Now, I am surprised that no one else mentioned this because I have not discovered anything new. In a 2015 foundational speech on inflation, then Fed Chair Janet Yellen noted that ‘another input cost that can affect core inflation is the price of energy’. ‘However’, she added, ‘in recent decades, the pass-through of energy price changes to core inflation appears much smaller than in previous periods.’

Chart 1 shows this. During the period of high inflation of the 1970s, energy and core inflation were highly correlated. But, once core inflation fell to low levels, it stopped being impacted by energy prices, as Yellen noted in 2015.

Fast forward seven years and a pandemic, and Yellen’s puzzle is explained by the BIS. Based on recent data work, the BIS found that inflation dynamics are very different when inflation is ‘high’ than when it is ‘low’.

Specifically, in a high inflation regime, price increases across all categories become correlated. And the passthrough from shocks (e.g., the exchange rate or commodities prices) becomes greater. By contrast, in a low inflation regime, price changes across categories remain largely uncorrelated, and inflation tends to be unresponsive to shocks.

What differentiates a high from low inflation regime is whether behaviours have changed, especially whether a feedback loop from wages to prices has taken root. And I believe that has already happened.

The BIS framework explains rather well the relationship between energy prices and core inflation over the past 50 years, including the recent slowdown in energy and core inflation.  It implies that a reversal in energy prices would see a renewed acceleration of core inflation.

More on this later, but first I want to discuss a riddle playing out in the background. It will not last more than 2-3 quarters, but it is large enough to be worth explaining: used cars.   

Used Car Prices to Drive Down core Inflation for a Few Quarters

In November, used car prices detracted 52bp from MoM core goods inflation of 51bp. This reflects the unwinding of an acute shortage of new cars during the pandemic. As a result, the ratio of used to new car prices jumped by 30ppt (Chart 2).

With new car shortages easing (but not fully resolved), the ratio of used to new car prices is falling, possibly headed to pre-pandemic norms or 15ppt lower. With new car prices stabilizing, used cars prices have much further to fall and will continue to detract from core inflation for a few quarters (Chart 3).

This used/new car cycle reflects economic normalization and will keep playing out independently of other price trends. The main drivers of core inflation currently are energy prices.

Energy Price Recovery to Rekindle Core Inflation

I do not know about you, but I am very puzzled by the decline in oil prices since June. It seems inconsistent with the global macro backdrop.

Most countries are still experiencing resource pressures, which suggests rising, rather than falling, commodities prices. On top of that, outside America, the world is experiencing energy shortages – just look at the Europeans’ desperate attempts to get hold of energy resources and ration their consumption. Energy shortages also suggest higher prices.

Further, we are leaving a decade or more of underinvestment in legacy energy sources as private investors do not want to hold an asset with zero residual value, and governments are focused more on the next election rather than long-term energy security.

I am not sure what is going on here.

Outside of gold, oil is one of the more financialized commodities (i.e., the ratio of futures markets open interest to physical production is high). And it could be that oil prices reflect Mr (and Ms) Market’s gloomy views on growth rather than growth itself. Also, the sanctions on Russian oil could have actually lowered global prices since it seems Russia, until recently the largest oil exporter in the world, has had to take a price cut to avoid them.    

Regardless, reality is likely to reassert itself (it usually does) and energy prices turn around. China’s reopening may well turn out a trigger.

Who knows? But when energy prices finally reverse, they are likely to rekindle core inflation.  In that context, the Fed could be a retardant or accelerant. Based on this week’s FOMC, an accelerant seems more likely.

Fed Policy Will Be Inflation Accelerant

As consensus and I expected, the Fed hiked the federal funds rate (FFR) 50bp to 4.4% at the meeting on Wednesday. Other than that, the meeting was fairly discombobulating, with Summary of Economic Projections (SEP) and presser at odds.

The SEP was dovish – and not just because it showed an increase in the median 2023 dot to 5.1%, against the 5.4% I was expecting. It continued to show a soft landing based on ‘immaculate disinflation’. The gap between the SEP-implied Taylor rule and nominal FFR was unchanged from the September SEP, and the SEP-implied real 2023 dot increased by 10bp only.

In addition, the Fed raised its 2023 core PCE forecast by 40bp relative to the September SEP (Chart 4). When asked why policy was not targeting a lower PCE in 2023, Chair Jerome Powell did not provide an explanation but simply stated that the 2023 PCE forecast reflected a higher outturn in 2022.

By contrast, the presser was hawkish. Powell made it clear that an increase in the inflation target is unlikely anytime soon: ‘we’re not considering that and not going to consider that under any circumstances.’ This was as I expected, but it is still good to hear Powell say it.

Powell did not rule out a further increase in the terminal FFR or another 50bp hike in February and stressed that the policy stance was still not restrictive enough.

The contrast between the SEP and presser could reflect that, as Chair, Powell is more in control of the presser than the SEP. SEP inputs are produced independently by individual meeting participants, who include Board governors and the 12 regional Fed presidents. The Board members tend to be more influential than the regional Fed presidents, and the Biden administration has appointed five of the of the current seven. I think the Board has become more dovish than the Chair.

With a Board that tilts dovish, the risk is that the Fed will lift its FFR trajectory only once it has become clear that inflation is moving to a higher path, i.e., too late. By that time, the wage price will be more entrenched and the output cost of lowering inflation higher.

Market Consequences

The market is pricing a terminal FFR about 25bp below the SEP and an end-2023 FFR 75bp below the SEP, i.e., 50bp cuts after the Fed hits the terminal rate in Q2 2023.

I disagree. Shorter term, as Powell explained, the Fed’s game plan will be driven by data and financial conditions. The market reaction to Wednesday’s FOMC meeting suggests a further easing of financial conditions. Together with strong employment growth and moderate inflation prints, this could support a 50bp hike in February, compared with about currently 30bp priced in.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed, the IMF, and the World Bank. She joined Macro Hive soon after its inception.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)