The Breakdown - Will Negative Inflation Prompt a Shift in Fed Policy?

Starting point is 00:00:00 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 produced and distributed by CoinDesk. What's going on, guys? It is Thursday, January 12th, and today we are talking inflation. For the sixth month in a row, headline inflation has gone down. Before we get 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, come join us on the Breakers Discord. You can find a link in the show notes. We go to bit.ly slash

Starting point is 00:00:42 breakdown pod. All right, friends, we are in the macro side of the house today because today is inflation day. The first Thursday in a new month is when we get the official inflation data from the month previously, and this one has definitely felt a little more significant than some in the past. We've had relatively good inflation prints for the last couple of months, and traders seem to think that coming into this one, the stakes were a little bit higher, like this one might have more of an impact in showing the Fed that there actually was a trend than those previous reports. The basic narrative before this print was that everyone was expecting CPI to come in cold, with a fair chance that it would show month-over-month deflation. Because of that, it had been a

Starting point is 00:01:26 partial driver of the current rally. Now, the concern, of course, would be that markets were getting ahead of themselves and that the print would end up coming in hot. Estimates overall were for a 6.5 headline inflation and 5.7% core inflation. For some context, remember in November had 7.1% headline inflation and 6% core. Joe Wisenthall from Bloomberg said happy CPI day to all who observe. Economist looking for a 0.3% month-over-month core reading. That's an acceleration from last month's 0.2% number. On a year-over-year basis, headline CPI is expected to fall from 7% percent.

Starting point is 00:02:00 point one to 6.5%. Cold-blooded Schiller writes, honestly, I kind of like J.P. Morgan's overview of CPI tomorrow. Quote, investors are largely defensively positioned. Any evidence that the Federal Reserve's inflation fighting campaign is working will spark a rush to unwind bearish positions. This could aid the nascent bear rally,

Starting point is 00:02:18 but we remain cautious as long as the Fed remains active with its tightening cycle. Our scenario analysis is skewed bullishly based upon positioning that could cause an overreaction via short covering on a dovish print. Schiller follows up and says, I think the bullish reaction tomorrow on a positive print could really be huge for equities in this rally and a real ignition point for the next week into earnings. Despite my overall bearish bias, I'd be happy to take up longs if we get it, volatile times ahead. Jim Bianco says quick thread on tomorrow's CPI.

Starting point is 00:02:46 The consensus outlook for December 22 month-over-month CPI is negative 0.1%. Deflation. Deflation is expected and already priced in. December year-over-year CPI print is expected to drop to 6.5. 5% from 7.1% in November. Wall Street wants to believe negative 0.1% will be a stunner, causing the Fed to only, quote-unquote, hike 25 basis points on February 1st, and risks can rally. The reality is that 0.1% is expected, and the market has priced in a 25-bases point hike on February 1st for a month, so weak inflation is expected and already priced in.

Starting point is 00:03:19 A downshift to a 25-bases point hike is already priced in. These are aggressive numbers and must be beaten for tomorrow's report to be considered bullish. Bob Elliott, the CIO at Unlimited Funds, writes, squinting at the CPI components tomorrow has the risk of losing the forest for the trees. While goods inflation has moderated, it is probably not going back to pre-COVID levels over time, and there is little indication that services inflation is moving back to the Fed's target. The key issues that the Fed has faced with inflation are first, a supply-driven shock, caused many goods, particularly durable goods, to rise in price.

Starting point is 00:03:51 Fiscal stimulus helped finance that spending. That is moderated. Then the war created another inflationary impulse that caused non-durable goods, much of which food, oil, and the like, to rise. That has since reversed. Both are now creating disinflationary impulses. The question is where these will settle in an environment of de-globalization, just in case inventorying and tight commodity markets. They may fall further, but odds are will settle at a higher level than pre-COVID. That leaves the biggest inflation problem which is coming from services inflation, and the biggest driver of services inflation is wages. The Fed's challenge is wages continue to grow at a relatively strong pace. AHE caught folks' attention,

Starting point is 00:04:29 but shifting job mix drove part of the change. Like-for-like measures have peaked but remain high. A critical question is where they settle. That's where the Fed's focus on the labor market comes in. Services prices are driven by wages, and wages are driven by the tightness of labor markets. Unemployment remains at secular lows, and wage growth on a like-for-like basis remains 5% to 6%. Unemployment running at this pace will continue to create labor wage pressure, which will continue to create pressure on services. Put together, it seems clear why the Fed believes that it hasn't sustainably solved the inflation problem. Of course, CPI or PCE may kiss 2% this year, but that's not the important question. The question is whether it can durably remain at that level. To do that,

Starting point is 00:05:09 it will most likely take a considerable weakening of services inflation. It is very unlikely for that to happen with the employment rate at secular lows. Maybe the Fed has done enough, in which case, the rosy scenario in stocks doesn't make sense. Or the Fed hasn't done enough and recession pricing in bonds doesn't make sense. Either way, markets aren't reflecting what needs to happen. Bob wasn't the only one who had a little bit of concern seep into their threads. Market and mayhem wrote, the market has decided to try once again to front run a Fed pivot. Participants no longer believe in the credibility of what the Fed is saying. This is dangerous. Inflation may have peaked, but the threat it presents is far from over, especially if we go back to easy money.

Starting point is 00:05:48 The Fed has the capability to increase the cost of capital and remove liquidity from the global financial system to destroy demand by eroding wealth effects, slowing the economy, and making debt more expensive. But that doesn't work when the stock and bond market fight it. If this were any other situation, and we didn't have a problem with a lack of supply-side elasticity, I'd say, sure, the Fed could pivot because history suggests as much during periods of low inflation when we're facing a recession. This is not a period of low inflation. With one of inflation's drivers being a lack of supply-side elasticity, something of the Fed cannot do anything to address. The biggest risk is a normalization of demand, because in that scenario,

Starting point is 00:06:24 inflation can not only come back in any meaningful way, but from higher base prices, too. In such a scenario, because very little has been done to increase supply, we would see another spike in inflationary pressure, and it would be even more cumbersome to try to address it. Two-thirds of consumers already live paycheck-to-paycheck and are borrowing to buy necessities. So be careful what you wish for. The idea of undermining Fed policy when in this situation they're actually trying to do the right thing is problematic. But I don't think they will budge on their resolve. The more the market fights the Fed, the more pain there will be, in my opinion.

Starting point is 00:06:56 At the end of the day, the only way we can subdue inflation is work on both slowing demand and increasing supply. But governments around the world seem oblivious to the latter, and that's a significant impediment toward making any discernible progress. That makes the job of central banks, like the Fed, that much harder. which is why we've heard speakers say that they need help on the supply side, and they aren't getting that help, compelling them to do as much as they can to destroy demand. Ultimately, this game of tug-of-war with market participants actively fighting central banks is likely to end poorly for everyone, and particularly the people who are struggling to make ends meet and borrowing to do so. So take a moment the next time you question the credibility of the Fed to wonder what the implications of that truly are. They're anything

Starting point is 00:07:34 but good. And it's unlikely that the Fed will blink this time because this time is different due to the inflationary dynamics involved. So there's a lot to unpack in that threat. I think the two things that stand out to me are one, the fact that in the absence of there being real progress on increasing supply, the Fed's only tool is what they can do, which is destroy demand. It might not be the right remedy for the economy, but it's the only tool that the Fed has. The second piece is, of course, an echo of what we've heard over and over again from the Fed, which is that market exuberance is one of the major impediments of them actually enacting these policies. This was basically the big theme of the December FOMC notes that we got earlier this month. It was a concern that markets

Starting point is 00:08:16 were going to get out ahead of themselves, which would, in and of itself, undermine Fed policy and make it more difficult for the Fed's disinflationary policy to actually have the impact that they wanted. I think market and mayhem is right that the markets are kind of shooting themselves in their foot for pushing so hard and acting like there's an imminent pivot. At the same time, it's pretty understandable why the Fed's credibility is at such a low. They spent basically all of 2021 with their heads in the sand ignoring this inflationary problem when basically everyone outside of their establishment was saying that this was going to be a problem, and this is the consequence that markets just don't buy it and no longer take them at their word. It is, as marketed mayhem

Starting point is 00:08:55 points out, a very difficult situation. Mark Andre Fongren says, markets say inflation has been falling for weeks, rate hikes, and Fed hawkishness are virtually passe. Let's fight the Fed. The Fed says higher for longer. We'll most likely be hiking higher than intended. Don't fight us on this. Get your popcorn ready. So when all was said and done, what did we actually get? This time, the economists absolutely nailed it. Headline inflation was 6.5%, just as expected. Core year-over-year inflation was 5.7%, again, just as expected. Month over month, core was up 0.3% as expected. And yes, the overall month-over-month headline CPI fell 0.1%, the first decline in two and a half years. Joey Politano did some rapid analysis writing, here's what drove CPI this month.

Starting point is 00:09:42 Big negative contributions from core goods, especially used cars and energy, especially gasoline, more than canceled out the large positive contribution from core services, which includes housing, and a small positive contribution from food. Year-on-year CPI inflation in the U.S. is now fundamentally a story of two categories, food and core services, which includes housing. A year-on-year contribution from energy and core goods is rapidly dwindling and likely to turn negative soon. Join CoinDesk's Consensus 20203, the most important conversation in crypto and Web3,

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Starting point is 00:10:35 to get 15% off your paths. Visit consensus.com or check the link in the show notes. Now, in terms of the things that were driving inflation, housing was a big piece of it. Year over year, housing prices grew 8.3%

Starting point is 00:10:54 according to this survey. That's the highest level since 1981. At the same time, measures of rent prices tend to lag market conditions pretty significantly. And given that, rent inflation should also be peaking in the months to come. Now, in terms of taking a wider view,

Starting point is 00:11:09 Politano writes, let's imagine you want to look at supercore inflation in the CPI, exclude food, energy, and used cars, all of which are volatile, and then take out shelter, which lags current market conditions. That figure grew less than 2% annualized over the last three months. Harvard economist Jason Furman agreed with this. He said excluding housing, which is about 40% of core and used cars, supercore inflation was consistently modest for the last three months, a 1.8% annual rate over this period. That's the lowest since February 21. Now, given all this, the vast majority of the coverage was around what it likely means for monetary policy. Joe Wisenthal had recognized the stakes. Just before the CPI announcement, he tweeted,

Starting point is 00:11:47 for the last year or so, CPI has been as big of a deal, if not more so, than the jobs report. But I think the stakes are unusually high for today's, given that it's coming at a time of serious debate about the possibility of a soft landing and downshifting and fed hiking. Most of the coverage had this CPI report cementing a Fed cooldown. Bloomberg wrote, the data, when paired with prior months lower than expected readings, point to more consistent signs that inflation is easing and may pave the way for the Fed to downshift to a quarterpoint hike at their next meeting ending February 1st. Shortly after the report was released, Philadelphia's Fed President Patrick Harker said the central bank should lift interest rates in quarter point increments going forward as it approaches

Starting point is 00:12:23 the endpoint in its hiking campaign. Bloomberg economist Anna Wong wrote a mostly favorable December CPI report gives the Fed room to further downshel. shift the pace of rate hikes to 25 basis points at the January 31st to February 1st meeting. We expect the Fed funds rate to peak at 5% in March and stay at that level for the rest of the year. Fed busperer Nick Timmeros also juiced this narrative with his piece titled Inflation Report Tees Up, likely quarter point Fed rate rises in February. Macro Alf wrote about what Jerome Powell might be thinking right now based on what we've seen in the past from him. He writes very important CPI report for the Fed and markets.

Starting point is 00:12:58 Here here, inflation is coming down and it will continue to do so. especially in the second half of the year. Fixed income traders strongly agree. The inflation swap curve prices CPI below 3% by the end of 2023. Notice, bond market predictions can be wildly wrong and they have been in the past. Luckily, analyzing CPI prints has become easier. In a speech a few months ago, Powell told us how he is going to look at inflation reports. He focuses on three main categories, goods, shelter, and core services excluding shelter. Why this split? Because of the following. goods inflation is a post-pandemic distortion, not a structural driver of inflationary pressures that would worry the Fed. Goods prices are cooling off, and Powell is aware of this, but it's not his main focus.

Starting point is 00:13:39 Rent or shelter is likely to keep pushing higher for another three to four months, as it merely reflects the 2022 booming housing market. Due to calculation methodologies, it's nothing else than a lagging indicator. It represents a large portion of core services inflation, but the Fed looks at it as a separate category. Finally, what we should really pay attention to, core services excluding shelter. In particular, Powell is focused on the momentum of price pressures that he identified as the three-month moving averages. The three-month moving average of month-over-month core services excluding shelter CPI has dramatically slowed down, and it's now in line with a 2.5 to 3% annualized core inflation. This matters a lot to Powell.

Starting point is 00:14:16 So there you go. This was a pretty bullish print, and to Jim Bianco's point, yes, it was largely assumed and priced in already, but it's bullish not in the sense of a short-term price rally, but more in terms of the the trend line. I don't think we're out of the woods yet, and I do think that this concern brought up by market and mayhem earlier in the show around how much markets could undermine Fed policy, and in so doing, extend the duration of Fed tightening, is a really important question and consideration. But even with that, it's still about as good a report as we've seen for more than a year. So that's something to be excited about on this Thursday morning. Until tomorrow, guys,

Starting point is 00:14:53 be safe and take care of each other. Peace.

The Breakdown - Will Negative Inflation Prompt a Shift in Fed Policy?

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