“April’s inflation figures came in hotter than expected and there are plenty of signs suggesting tomorrow’s report on May CPI will only add to that trend. As a result, you might think that markets may begin to price in an inflationary consensus. You would be wrong.” That’s what I wrote this time a year ago but it remains true today, the only difference being that the inflation numbers are now nearly double what they were then. Friday’s CPI report showed headline inflation in May running at 8.6% year over year, the fastest rate in over 40 years. Still, markets are discounting a future in which inflation peaks right about now and then falls back to its long run trend very rapidly.
"While the move in discounted inflation can look big up close, it's actually modest by historical standards. It's nothing like what we saw in the 1970s and what we'd expect to see when markets price in a secular shift in inflation." https://t.co/2Y3UkU6sYA pic.twitter.com/hzhTVMzWhA
— Jesse Felder (@jessefelder) June 14, 2022
As former Fed Chief Ben Bernanke wrote recently, the single most important factor in reining in inflation is the public’s confidence in the central bank’s willingness and ability to make it happen.
"Inflation will not become self-perpetuating, with price increases leading to wage increases leading to price increases, if people are confident that the Fed will take the necessary measures to bring inflation down over time." -Ben Bernanke https://t.co/RRH8WrYSJr
— Jesse Felder (@jessefelder) June 14, 2022
The trouble is that because the Fed’s forecasts for inflation have been so terribly wrong for so long now, it may be hard for the public to maintain that faith.
"The Fed’s forecasts from March, saying that inflation would be coming down to 2 by the end of the year was, frankly, delusional when issued, and looks even more ridiculous today. Those mistakes mean they don’t fundamentally have credibility." –@LHSummers https://t.co/4voGjQd1dE
— Jesse Felder (@jessefelder) June 11, 2022
The longer extreme price pressures persist, the greater the chance that that faith is lost completely.
Consumer stress: average of utility costs, gasoline, food at home, and electricity components of May CPI #inflation (in y/y terms) surged by 25.7% (just slightly less than peak in 1980) pic.twitter.com/YfYcPsp4p4
— Liz Ann Sonders (@LizAnnSonders) June 13, 2022
Furthermore, markets are not only pricing in a rapid return to normal in inflation; they are assuming that a terminal fed funds rate of less than 4% will get it there.
Extraordinary. Markets now pricing in Fed terminal rate of 3.90% in June next year, up 100 bps in just over two weeks. Deutsche Bank the the first major house to forecast above 4%. pic.twitter.com/M8QeB1K33n
— Jamie McGeever (@ReutersJamie) June 13, 2022
4% might seem like a very restrictive rate in the context of recent history. However, relative to the current inflation rate it’s hard to argue it’s not still highly accommodative. Technically, policy wouldn’t really become restrictive until the fed funds rate rises above the inflation rate.
"Once inflation gets above 5% it's never come down unless fed funds have gotten above the CPI. Frankly I don't think we'll get there because the extent of the asset bubble and the damage that would be done." -Stan Druckenmiller https://t.co/VrPpnkADhk
— Jesse Felder (@jessefelder) June 13, 2022
The truth is that the current monetary policy framework is the most accommodative in modern history, more so than even the most accommodative policy seen during the Great Inflation of the 1970’s.
'Our new estimates imply that the current policy gap (12.7%), measured as the difference between core inflation and the real federal funds rate, is already roughly equal to the peak gap of the Volcker-era (12.1%).' https://t.co/yPn56KIN6x pic.twitter.com/TRI2A9WHBF
— Jesse Felder (@jessefelder) June 6, 2022
As Stan Druckenmiller points out, however, a truly restrictive monetary policy setting is simply not possible given the still extreme valuations in the financial markets and the fact that the economy may already be headed for recession even with the fed funds rate still very deeply negative in real terms.
'If the U.S. economy is to avert a recession, something will have to give. It may well be the Fed's inflation target.' https://t.co/1lEm8WzJVX
— Jesse Felder (@jessefelder) June 9, 2022
As a result, the Fed may soon be forced to put its inflation-fighting goals on hold even as inflation remains well above its 2% target. If so, the markets may have a great deal of future inflation to discount into asset prices.
— Jesse Felder (@jessefelder) May 28, 2022