2023-07-10 11:53:18 ET
Summary
- The BIS Annual Economic Report 2023 discusses the challenges of fighting "last mile" inflation, predicting a more difficult phase of disinflation ahead.
- I compare the fight against inflation to a race, using strategies from track and field to illustrate how the Fed should approach interest rate hikes.
- The Federal Reserve's current approach suggests it should get ahead of inflation and shift into a more aggressive tightening policy when necessary.
Inflation fight - The last 100 meters
BIS Annual Economic Report 2023 discusses the macro challenges with "last mile" inflation fight, and states that "the next phase of disinflation may become more difficult."
The concept of "last mile" is likely based on a marathon. I competed in 400M/800M events, so I'm familiar with the "last 100m" concept - that's when the lactic acid kicks in and the legs get heavy, but you have to keep moving.
I was coached by Que McMaster who worked with the great Micheal Johnson (four Olympic gold medals) in his early days at Baylor, and he had a scientific approach to the "last 100m" problem. The data showed that you can sprint at max speed for 20-25 seconds without triggering lactic acid, so you start really fast, and then you switch into the "glide mode." The secret was to switch from the "glide mode" to the "finish mode" efficiently, so you can cross the finish line at full speed - without ever triggering lactic acid. The strategy was to get ahead of the competition, and if they never catch up, you win, and if they do catch up, you have enough energy to switch into the higher gear in the last 100m and still win.
The Fed is doing it all wrong
The Fed is essentially in a race against inflation. Drawing lessons from McMaster's race strategy, the Fed is supposed to get ahead of inflation - and if inflation accelerates, shift into a more aggressive tightening mode until the clear victory. In fact, that was exactly the Fed's strategy in the 1970s/early 1980s. Here's the graph that shows core PCE inflation (in blue) and effective Federal Funds rate (in red):
What do we see? When inflation is rising, the Federal Funds rate (red) always is above the core PCE (blue). But more importantly, near the peaks in inflation, the Fed would accelerate the hikes - well above the PCE inflation. That's how you win the race.
For example, in March 1980, the Fed hiked from 14% to 17%, while core PCE was at a peak of 9.3%.
And now let's look at the current situation. The Fed let inflation get ahead by far in 2022 by wrongly assuming that the inflationary spike was "transitory." The Fed finally caught up with inflation in May 2023 - and then paused? What a mistake. Why? Because it appears that inflation is about to turn higher. It appears that inflation is being coached by McMaster. So, the "last 100m" of this race will be very interesting.
Is inflation turning higher?
The BLS will release the inflation data for June 2023. These are the expectations:
So, the headline inflation is expected to sharply fall to 3.1%, but the month-over-month inflation is expected to rise to 0.3%. Core CPI is expected to slightly fall to 5%, while the month-over is also expected at 0.3%.
The Cleveland Fed Inflation Nowcast predicts slightly higher numbers for June, with CPI at 3.2%, and core CPI at 5.1%, with a 0.4% month-over-month increase for both. Thus, we could get a higher-than-expected number for June.
Cleveland Fed | Cleveland Fed |
But, more importantly, Nowcast predicts higher CPI and core CPI for July at 3.6% and 5.2%, respectively. Even more worrisome is the constant 0.4% month-over-month increase for the core CPI, which is consistent with a steady 5% annual core inflation.
In fact, the annualized quarterly inflation for Q3 is expected to rise to 4.42% from 3% - that's a sharp upturn in inflation.
Why is inflation rising again?
First, inflation is estimated as a 12-month year-over-year increase in prices - so each month you delete the month a year ago from the calculation. Well, last year there was a spike in energy/food prices due to the war in Ukraine, and the peak was in June, so the inflation number for July deletes the June 2022 number - that's the base effect for the headline CPI, and it looks like this (the big bar is out of the picture for July):
And this is the month-over-month inflation for core CPI:
The most important data to look at is the fact that over the last six months, the month-over-month core CPI inflation was steady at 0.4%, which is expected to hold for at least the next two months, based on Nowcast. That's consistent with over 5% annual core CPI - while the target is 2%.
So, once the base effects are out, we are facing the "last mile" or the "last 100m," and BIS said this will be a very difficult race. Specifically, BIS is very concerned that there could be a price-wage inflationary spiral in making. When looking at the totality of data, BIS concludes that there's a high risk of a transition to the 1970s-like high-inflationary mode. More info here .
What does the Fed need to do now?
The Fed started the race from behind and has been trying to catch up. In order to win the race, the Fed needs to accelerate the monetary policy tightening, well above what is currently expected. Just look at the chart provided above, the red line has to be well above the blue line, there's no other way. In other words, the Fed might need to surprise the market with a 50bpt hike in July. That's the transition to the "finish mode," and that's what worked in the 1970s. The Taylor rule tool also suggests that the Federal Funds rate should currently be somewhere between 6.6-7.2%.
The race is over when we see a consistent 0.1%, 0.2% in core PCE for several months. Unfortunately, this might require a very sharp increase in the unemployment rate, possibly above 6%-7%.
Implications
This is the Fed's strategy for the "last mile" or "last 100m" of the inflation race: stay behind and wait for inflation to get "tired," or wait for inflation to get "the lactic acid" and just die out.
This strategy is unlikely to work, and the Fed will be forced to be more aggressive - to shift into the "finish mode." However, this will likely cause a deep recession. In fact, there are already signs that growth is stalling or contracting based on the real GDI measure, and yet inflation is expected to turn higher after the June reading.
The BIS report is particularly worried about the housing sector if the Fed is forced to hike 200bpt above the May rate to above 6%. In this scenario, the housing prices would drop below their 2012 level or more than 33% from the peak. This might be required to bring inflation to 2%.
The financial sector ( XLF ) is at the center of the upcoming crisis, given the expected fall in housing prices, and the expected solvency issues in the commercial real estate ( XLRE ).
Regional banks ( KRE ) are likely to be most vulnerable, given their heavy exposure to commercial real estate and mortgages. In addition, the further expected increase in the Federal Funds rate will continue to increase their cost of capital and accelerate the deposit outflows. Thus, it's likely that many more regional banks would fail.
For further details see:
CPI Preview: Disinflation Is Finished - Inflation To Start Rising Again