PLW - Inflation Not Over - Fed Will Tighten Again In 2023

2023-07-19 08:30:00 ET

Summary

• Inflation is not over, and the Federal Reserve will tighten again, despite the latest Consumer Price Index reading.
• Housing costs made up the largest portion of the latest CPI increase, and the optimists note that both rents and home prices have stopped rising, and in many cases have come down a bit.
• If inflation had been just about supply chain disruptions, prices would not only have stopped rising, they would have come back down to their old levels.

Inflation is not over, and the Federal Reserve will tighten again, despite the latest Consumer Price Index reading. That report showed the overall CPI rose just 3.0% in the 12 months through June 2023. A year earlier CPI inflation peaked at 9.1%.

Recall last year’s arguments about how transitory inflation would be. The transitory argument emphasized supply chain problems. If we can’t get all the stuff through the ports, then the portion that does get through will be sold at a premium. Later, when the ports are unclogged, more stuff gets through and prices come down to where they would have been without supply chain problems. But that’s a small part of the inflation story.

The government injected a huge amount of stimulus into the economy in recent years. Federal government expenditures had been $4.5 trillion the year before the pandemic, then soared to $6.5 trillion the next year. They dropped to $6.3 trillion last year, with stimulus payments done. That’s still 41% above the pre-pandemic level.

Not only was fiscal policy highly stimulative, but the Fed used monetary policy to goose the economy. The year 2020 began with the Fed holding $4.1 trillion in assets. By year-end, that had ballooned to $7.4 billion, as the Fed printed virtual money to buy Treasury bonds and mortgage-backed securities. They pushed their assets up to $8.9 trillion in March 2022, then they finally began to tighten.

Throwing trillions of dollars into an economy which has had little growth in its productive capacity had to be inflationary. But that’s the past. The future holds more inflation. On the fiscal policy side, the Office of Management and Budget in the White House projects a small increase, 1.6%, this fiscal year (ending September 30), to be followed by an 8.0% jump next year. The Fed’s tightening has pulled its total assets down by less than one-tenth of one percent. Yes, short-term interest rates have been pushed up by five percentage points, but most of the money that was created is still in the economy.

Housing costs made up the largest portion of the latest CPI increase, and the optimists note that both rents and home prices have stopped rising, and in many cases have come down a bit. While that’s true, it’s a misleading way to look at inflation . The money is still in the economy, and it will be spent. Many people now find that buying a house looks like a bad deal, given high mortgage rates and prices at a high level but not rising. And renters who had gotten rid of their roommates find that inflation has forced them to accept sharing an apartment with someone. But there’s still money left over, even if not enough to live alone.

The mechanics of how the CPI is constructed is useful for folks on Wall Street trying to figure if the next inflation report will be above or below market expectations. But the big picture of the economy is that inflation will continue until all of the stimulus has worked through the economy. The higher price level itself means that the real value of stimulus (the inflation-adjusted value) is being worked down. Federal Reserve tightening, though must continue in order to bring inflation down.

The Fed’s commitment to anti-inflation policy looked doubtful in 2021, but they proved the skeptics (including me) wrong with strong medicine applied in 2022. Look for the Fed to push short-term interest rates up a quarter point at their July 25-26 meeting, with probably another quarter-point hike at a subsequent meeting. Then the Fed needs to let those rates remain high for about a year. The Fed won’t relent at the first sign of labor weakness. So don’t expect lower interest rates anytime in the next 12 months. Probably in 2025, though there’s a small possibility that short-term rates will come down late in 2024.

Long-term interest rates, such as 30-year mortgages and 10-year Treasuries, will drop in anticipation of the Fed easing, but probably not until mid-2024. In the meantime, long rates will gyrate as bond traders say to themselves, “Is it now?” And after a month of disappointment, “Is it now?” And a month later, “Is it really now, yet?”

If inflation had been just about supply chain disruptions, prices would not only have stopped rising, they would have come back down to their old levels. John Cochrane summed it up nicely (about the 13 ^th minute), saying that strawberry prices rise in the winter because of reduced supply. But that does not cause inflation, a continued rise in prices. Instead, strawberry prices come down the next summer as supply resumes. We’ve had too much stimulus in this economy, and it’s not yet flowed through the economy.

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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