The Breakdown - For Once, a Positive Inflation Surprise

Episode Date: December 15, 2022

This episode is sponsored by Nexo.io, Circle, Kraken and the Galaxy Brains Podcast.   On today’s episode, NLW catches up on the most recent inflation numbers. U.S. headline inflation for November came in at 7.1%, vs 7.7% the previous month and the 7.3% expected by surveyed economists. The Federal Reserve’s preferred measure of core CPI was up just 0.2% month over month. This show looks at the numbers and market reactions, as well as what it might mean for the Federal Open Market Committee interest rate decision expected on Wednesday, Dec. 14.  - Nexo is a security-first platform where you can buy, exchange and borrow against your crypto. The company ensures the safety of your funds and keeps innovating with products like the Nexo Wallet - a non-custodial smart wallet that allows you to create your Web3 identity. Get early access at nexo.io/wallet. - Circle, the sole issuer of the trusted and reliable stablecoin USDC, is our sponsor for today’s show. USDC is a fast, cost-effective solution for global payments at internet speeds. Learn how businesses are taking advantage of these opportunities at Circle’s USDC Hub for Businesses. - Kraken, the secure, trusted digital asset exchange, is our sponsor for today's show. Kraken makes it easy to instantly buy 185+ cryptocurrencies with fast, flexible funding options. Your account is covered by regular Proof of Reserves audits, industry-leading security and award-winning Client Engagement, available 24/7. Sign up and trade today at kraken.com/breakdown. - Galaxy Brains: Whether it’s breaking down market volatility or analyzing the latest development, come for the latest market insights from our in-house trading professionals and renowned experts from across the industry. Stay for the occasional rap from host Alex Thorn. Check out the latest episodes here: https://www.galaxy.com/research/podcasts/galaxy-brains/?utm_source=BD&utm_medium=podcast&utm_id=CoinDesk - “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with editing by Rob Mitchell and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsors today is "Back To The End" by Strength To Last. Image credit: OsakaWayne Studios/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexo.io, Circle, and Cracken, and produced and distributed by CoinDesk. What's going on, guys? It is Wednesday, December 14th, and today we are talking inflation. Before we dive into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.com slash breakdown pod. I'm excited to also share that this week the podcast is brought to you by

Galaxy and the Galaxy Brains podcast. Transparency is more important than ever in crypto. If you're here, it's obvious how important it is to you to find reliable information. For more shows like this, for more shows like The Breakdown, check out the Galaxy Brains podcast. To tell you a little more, here's the host Alex Thorne, Galaxy Head of Research. Listen each week as we take you inside the biggest stories and projects in Bitcoin and crypto. Whether it's breaking down market volatility or analyzing the latest technical developments, Galaxy Brains has you covered. Come for the latest market insights from our in-house trading professionals and renowned experts

from across the industry. Stay for the occasional rap from yours truly. Check it out at galaxy.com slash research. All right, friends, how are you doing? It's another day in crypto. There is a Senate hearing going on with not one but two TV personalities, which I am keeping an eye on but can't really bring myself to watch entirely. The other news update from yesterday's show that's worth noting is that Sam's request for bail was denied. He has been reprimanded to a penitentiary in the Bahamas until he's extradited or another hearing that's scheduled for February 8th.

Sam was, I think, appropriately deemed too much of a flight risk. Anyway, today we are not focused on that particular corner of the world. Instead, we're going to shift our focus back over to the macro. Throughout the year, up until the beginning of November, when the whole FTX saga began, crypto had been highly correlated with stock prices. In fact, all risk assets were basically moving in lockstep. That was because, for the first time in more than a decade, the Fed was making a dramatic secular shift in monetary policy.

Their focus had switched. No longer would they be propping up the economy and keeping things working smoothly during COVID and the attendant shutdowns and reopenings, but instead the name of the game was fighting the scourge of inflation, an inflation which resulted from some highly debated combination of factors. Now, as we know with the benefit of hindsight, the Fed waited much too long to shift course, and so has been forced to take dramatic action this year, raising interest rates at a pace not seen for 40 years. For much of the year, the entire Fed apparatus, as has been in lockstep behind Chairman Jerome Powell. There has been an agreement around the importance of tamping down inflation, of keeping inflation expectations moored, and a fighting

to make sure there was no wage price spiral. Lurking behind the Fed's action has been a very public fear of reversing course too soon, of not tightening to the point where inflation was completely strangled. Powell and other Fedsters have often invoked the specter of the 1970s, when the Federal Reserve's inconsistent approach led to the need for Paul Volker's massive rate rises at the end of that decade in the beginning of the next, which also led to a massive recession. Now, Powell, for his part, has continued to argue that there is a path, albeit a small one, for a soft landing that doesn't include recession. But he's also made it clear that not only is he okay, with some job losses as the cost of beating inflation, but at this point,

the tightness in the labor market is one of his and the Fed's chief concerns. Now, also throughout this year, we've seen a predictable off-repeated pattern in markets, which is that markets convince themselves that the Fed is going to be forced to pivot soon to more accommodative policy for some reason or another, to which the Fed deploys some officials up to to including Jay Powell to say, hey, stop getting ahead of yourselves. There's a lot of fight left. And then as the market sadly retreat, some data point comes up proving the Fed's point. Sometimes that data point has been around jobs numbers, but surely the most important has been inflation itself. Which brings us to this week's inflation numbers. Like I said, up until November,

Bitcoin and crypto moved in lockstep with the rest of the risk asset world. But of course, it was in early November that FTX collapsed. That meant that many in our industry weren't paying attention when October CPI numbers came in, ultimately just a few days before FTX declared bankruptcy. Outside of our little archipelago of agony, October CPI numbers were welcomed by the market. The 7.7% headline inflation was the lowest it had been since January. It was down from 8.2% in September and 9.1% in June, which was the highest number since the early 1980s. Perhaps even more relevant for the Fed was CoreCPI. CoreCPI, of course, excludes food and energy, and in October, core was 6.3% year over year,

which was a welcome downshift from the surprise high 6.6% that we had seen in September. Month-over-month, Core CPI was 0.3% on October, which was down significantly from 0.6% in August and September. Now, while markets reacted pretty excitedly, there were a couple reasons to be cautious. The first was that a big part of the decrease was that medical care prices went down significantly, driven by a 4% drop in health insurance premiums that was caused by a once a year update on the underlying data, so maybe something to temper the overall excitement about the numbers. The second reason to be cautious was even more banal, and was the simple fact that it was just one good month, and one good month does not a pattern make. So, on Tuesday of this week,

yesterday, we got November CPI numbers, and the question was, would the downward trend hold? And the answer much to the excitement of markets was that it did. In November, the consumer price index increased by 0.1% bringing the annualized inflation rate to 7.1%. That came in under expectations of a 7.3% inflation print. Core CPI inched up by just 0.2% in November, which was the smallest monthly increase since August of last year, with the annualized rate at 6%. Asset markets viewed this as a sign that the worst inflation may already be behind us, allowing the Fed to back off its inflation fight. On the data release, stock futures jump by 3% and yields on two-year Treasury sank by 20 basis points. Although stocks get back almost all of this move throughout the trading day, the two-year bond

held at a lower 4.2% yield, representing the idea that the Fed may be almost done with its hiking cycle. Now, looking into what drove the reduction in inflation, there are a couple different factors. Energy costs, medical care, and used cars all played a part. Energy costs reduced by 1.6% in November, with all major categories bar of fuel oil seeing decreases. Medical care marked its second month in row of declining prices. Used cars saw a 2.9% reduction. for the month, extending a streak of monthly price reductions to bring annualized inflation to negative 3.3%. This is the only major category in the CPI basket experiencing deflation on a year-long time frame. Shelter, which is made up of rent, owner's equivalent rent, and out-of-home

costs like hotel accommodation, reduced to its lowest increase in four months. It rose by 0.6% on the back of a large reduction in hotel accommodation after a sharp rise in October. Rents and owner's equivalent rent both rose by more than the previous month, however, private sector data is showing that rents may have already peaked in a number of cities across the country. Shelter is a notoriously laggy component of CPI, with the data methodology feeding in changes to rent slowly over time to account for longer-term fixed pricing for renters. Shelter also represents the largest component of the services basket and a third of overall CPI. All of this is to say that a significant portion of the rotation of inflation from goods to services could simply

be laggy rents data catching up after two years of scorching hot rent increases. Broadly speaking, market commentators took the news optimistically. Lindsay Rosner, a multi-sector portfolio manager at PGM fixed income, said, quote, this was an important piece of the story of rate hikes working, first really meaningful beat. Charles Henry Monchow, the chief investment officer at Bank Siz, said, the biggest drivers of the lower print were energy costs, medical care, and used cars, but the very good news is that the softer read is widespread. Lots of folks also speculated on what it might mean for Fed policy. Paul Ashworth, the chief North American economist at Capital Economics, said, quote, the Fed could dismiss better than expected October as one-month's data,

but the further slowdown in November makes it harder to dismiss this new disinflationary trend. Art Hogan, the chief market strategist at B. Riley Wealth Management, said, this is the good news that is actually good news for markets. It will be too soon for the Fed to change their summary economic projections or the dot plot for Wednesday's meeting, but it should put a lid on how high the terminal rate goes. The terminal rate, in this case, referring to the highest that the federal funds rate is likely to get in 2023. Bryce Doty, the senior portfolio manager at SIT Investment Associates, said, Bring on the relief rally as the Fed is now much closer to feeling they have succeeded in reigning in inflation,

regardless of how much this new trend is due to the rapid rate increases in Fed funds. Finally, SD Dweck, the chief investment officer at Flowbank said, we're probably soon going to see the Fed shift to hire for longer as a focus instead of still higher. But for now, markets can be happy and hope the labor market starts to cool a bit more to confirm the Fed slowdown. In an ecosystem where innovation is the norm, it's the basics that are in the spotlight. Nexo is a company that has never put the safety of clients' funds in question. With over 50 global licenses, $775 million in insurance, and a real-time audit of custodial assets, Nexo sets an example for security standards in the industry.

Apart from keeping their 5 million clients safe, Nexo has kept building. They've just announced their non-custodial smart wallet. Visit nexo.io. That's n-exo.io and sign up today. This episode is brought to you by Circle, the sole issuer of USDC, and a leader in crypto that's held to a higher standard. USDC is a fast, safe, and efficient way to send money around the globe. USDC is always redeemable one-to-one for U.S. dollars and has over $45 billion in circulation as of October 13, 2022. Plus, Circle posts weekly reserve reports and monthly attestations of reserve capital,

letting users know that USDA is safe, transparent, and compliant with regulations. Just go to circle.com backslash transparency to see why USDC is a trusted staple coin. As one of the largest, longest-lasting, and most secure exchanges, Krakken sets the example for transparency and trust, while delivering on their mission to empower people with new ways to connect and transact. Millions of people around the world count on the Krakken mobile app as the easiest, safest, and most flexible way to start building their crypto portfolio. Cracken's industry leading security keeps your funds and information safe, and their award-winning client

engagement teams are available for support 24-7. Download the Cracken app on Google Play or the Apple App Store, or visit crackin.com slash breakdown to join. Now to the question that is being debated today, which is what is the Fed going to do at December's FOMC meeting, which has been happening for the past two days. The Fed is widely expected to step down the pace of its rate increases to 50 basis points when it delivers its decision later this afternoon. Central bank officials have been clear that one month of solid data will not be enough to confirm that the worst inflation is behind us. While there does appear to be the need for additional data, the FOMC will not meet again until the start of February, so we'll have time to gauge where

the economy is heading. Officials have been laying the groundwork since their last meeting for a pause to their hiking cycle within the next few meetings, following a prolonged period of holding rates higher for longer. This inflation print does add more credence to the argument that Dovish officials have been making that the Fed should pause rate hike sooner than previously forecast. As mentioned before, by and large, people are taking the news as positive. Mike Consol, the director of macroeconomic analysis at Roosevelt Institute, said things are pointing in the right direction. He writes, we've had single good months in the past year, hopes that we're quickly dashed with reversion. But now we have two in a row, the first in summer, fall 2021. But as opposed to

then, the underlying trends are all pointing in the right direction. There are two key things Powell has discussed. The first is the three things he recently said he is watching for. goods in deflation, housing peaked, and the rest of services to be cooling down. All three happened and happened again for the second month in a row. The second thing Powell wants to see is divergence between three-month inflation and six-and-month inflation. For the past year, they've all been lined up the same, a discouraging signal through the monthly noise of this and that.

But now we finally start to see a break downward. Obviously, there's a long way to go, but if you look on a further timeline to pre-pandemic times, when inflation was just below target, you can see that the three-month average decline looks even bigger. Macro-Alf wrote a similar thread. He says, inflation surprised on the downside, both headline and core CPI came in weaker than expected. Actually, only two of the 67 economists surveyed by Bloomberg expected a 0.2% or lower month-over-month-month-core CPI print. What caused the surprise? Energy and related services dropped. It was expected, but not as much. Most importantly, the deflation in core goods

picked up pace. For instance, used cars are now in outright deflation. In his recent speech, Powell divided inflation in three main categories. Core goods, he expects them to be in a disinflationary trend. Housing related, he knows it's going to take a while because of calculation methodologies, X Housing Core Services. This really matters to him. This is because X housing core services prices are the least distorted measure of the really sticky inflationary pressures in the U.S. In other words, the type of inflation the Fed wants to go away. It seems like the massive tightening of financial conditions is starting to work its way through the core of the economy and dent inflation. The other important thing for the Fed is the breadth of

CPI, that's also declining. The share of CPI components running at 4% annualized pace has dropped from 75% to 60% pretty rapidly. While the absolute level of inflation is high, these three conditions seem to be unfolding. Sticky X Shelter Core Services CPI moderating, breadth of inflation receding, overall inflation momentum declining. This is good news for the Fed, but Powell will want to prevent a massive rally in stock in bond markets. The only mistake he wants to avoid is to prematurely let the inflation fight go. In the 1970s, that was an expensive a mistake. Now the issue is that keeping animal spirits at bay isn't going to be easy this time as the evidence of a slowdown in inflation becomes more prominent. As the market

cements its expectations for sharply lower CPI ahead and a subsequent Fed pivot, stocks and bonds are putting in a rally that will challenge Powell. How is he going to handle that? Back to NLW now, certainly from my standpoint, this is one of the things that I'm going to be watching for at the press conference today, and we'll I'm sure share with you guys tomorrow. Now, again, going back to the immediate rate hike decision, Nick Timmeros, the chief economics correspondent at the Wall Street Journal, who's largely seen as the most in touch with the Fed, outside of the Fed, writes, the November CPI isn't likely to alter after the Fed's anticipated 50 basis point hike on Wednesday, but two months of moderating price pressures could

complicate deliberations over how much more to raise rates early next year and how long to hold them there. Now, Nick's notion of complicating deliberations gets at one of the key shifts that's happening inside the Fed right now, which is a more clear division into Hawks and Doves. Again, from Timmeros, doves think the Fed has done enough or maybe too much, and then inflation still has a lot of transitoriness to it. Hawks worry inflation is spreading into the wage base, making a recession mandatory. The first phase of the Fed's rate increases was big, fast, and relatively widely supported. The second phase is getting underway and divisions are emerging. The outlook for inflation and wage

pressure sits at the center of budding disagreements. So this is really the question here. Are the hawkish and dovish lines becoming more calcified, and who's going to win that internal battle. Now, there are some folks out there who are also looking at larger issues. Harris Cooperman, the writer at Adventures in Capitalism, thinks that the big question is all about China. He writes, everyone got excited this morning because the CPI came in a tad. Whoopee! The bigger story is that China is reopening. They're going to draw on every commodity globally.

What do you think that does the CPI in 2023? My hunch is we have a few more prints that show a slowing. Everyone decides that inflation is abating. then they get stunned when inflation is teens in Q223 and J-Pow doesn't know WTF to do. Luke Groman, as always, is looking at the widest possible view. He writes, Good news, Fed tightening has reduced inflation. Bad news? That inflation was the only thing standing between the U.S. government and a fiscal crisis. Now things get interesting. Let's watch. Octa thinks we're in for inflation waves. He writes, as inflation decelerates,

investors will think that's the end of it, not my view. This is a structural problem caused by secular forces, wage growth, commodity shortages, reckless fiscal spending, and de-globalization. Inflation develops through waves, we just saw the first one. So where do I's turn next? Well, obviously, the first key signal will be to watch what Powell and the Fed does at this Wednesday FOMC meeting, but then from there, the debates will likely turn to what happens in February. If December also shows a reduction in inflation, does that mean the hiking cycle is over? Also, what happens next for the global economy? Is this a blip and then we get a resurgence of inflation? Can the U.S. get anywhere near to

percent inflation before something else breaks. Are corporates correctly pricing in a global growth slowdown? These are the big questions as we head into 2023, and I'm sure that we're going to be spending lots of time on them next year. For now, I want to say thanks again to my sponsors, nexus.com.com.com, I know, Circle, Cracken, and Galaxy brains. And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace.