Inflation Expectations and Inflationary Psychology

The Federal Reserve’s aggressive fight against inflation has savaged financial markets. Along the way, I have taken note of bouts of navel-gazing over inflation indicators. Many of us have little operating experience navigating inflation, so perhaps it is natural to get sidetracked staring at an indicator or two that confirms a desire to see an end to inflation or that confirms the persistence of inflation. Since the U.S. last had an inflation problem over 40 years ago, the data samples are quite small for making conclusions for today’s unique mix of ingredients. Yet, since the Fed has expressed fears about entrenched inflationary psychology, consumer expectations for inflation have entered the basket of metrics used for assessing the Fed’s every move.

For example, back in April, 2022, Richard Corbin, a research professor at the University of Michigan who has directed the consumer sentiment surveys since 1976, issued this ominous warning in describing “inflationary psychology”:

“There is a high probability that a self-perpetuating wage-price spiral will develop in the next few years. Households have already become less resistant to paying higher prices and firms have become less resistant to offering higher wages. Prices and wages will continue to spiral upward until the cumulative erosion in inflation-adjusted incomes causes the economy to collapse in recession…

…Although consumers have increasingly expected higher inflation, they have also expected a strong job market and rising wages, especially among consumers under age 45. In the year ahead, wage gains will continue to reduce resistance to rising prices among consumers, and the ability of firms to easily raise their selling prices will continue to reduce their resistance to increasing wages. Thus, the essential ingredients of a self-perpetuating wage-price spiral are now in place: rising inflation accompanied by rising wages.”

Inflationary Psychology Has Set In. Dislodging It Won’t Be Easy” – Richard Corbin

Note well that the University of Michigan’s U.S. consumer sentiment survey showed 1-year inflation expectations last peaked in March at 5.4%. There have been encouraging signs from the subsequent drift downward. However, hopes were dashed that these numbers could convince the Fed to pause after October’s 1-year expectation of 5.1% delivered a significant jump from September’s 4.7%. In other words, at best, expectations may be stabilizing at high levels, especially with core CPI surprising to the upside in September. Note, Corbin warned about over-extrapolating trends from wiggles in inflation numbers:

“Another critical characteristic of the earlier inflation era was frequent temporary reversals in inflation, only to be followed by new peaks. That same pattern should be expected in the months ahead.”

Surveys of Consumers, University of Michigan, University of Michigan: Inflation Expectation© [MICH], retrieved from FRED, Federal Reserve Bank of St. Louis, (Accessed on 10/16/2022, note the data are updated only through August per agreement)

For reference, the 5-year inflation expectations remain just above 2% which indicates consumers are still clinging to confidence that over the “long-term” inflation will return to the “before times”.

Federal Reserve Bank of St. Louis, 5-Year, 5-Year Forward Inflation Expectation Rate [T5YIFR], retrieved from FRED, Federal Reserve Bank of St. Louis, October 16, 2022.

Corbin wrote on the heels of the Fed’s first rate hike which was a mere 25 basis points. Corbin reacted with dismay and presciently argued:

“What was perhaps more surprising was that the quarter-point hike the Fed adopted in March was simply too small to signal an aggressive defense against rising inflation. Instead, it signaled the continuation of a strong labor market along with an inflation rate that would continue to rise.

Much more aggressive policy moves against inflation may arouse some controversy. Nonetheless, they are needed.”

Apparently, the Fed got the message and has been aggressively hiking starting with May’s rate hike!

If inflation expectations remain stubbornly elevated, then the time when the Fed is finally forced to take a pause could present a critical juncture of economic tension. In this scenario, I expect those who applaud the Fed’s pause will dismiss on-going high inflation expectations as transitory or even uninformed. Watch out if those expectations achieve new highs in the wake of a Fed pause.

The current controversy about aggressive policy demonstrates an instructive contrast with the last tightening cycle. What a difference pace can make! The S&P 500 (SPY) (red line with scale on the right) had little problem drifting higher while the Fed tightened with baby steps from 2016 to 2018. A sharp correction in late 2018 helped to convince the Fed to pause and then bring rates down. Market participants are still waiting for the Fed to care about the current market sell-off in the wake of higher rates.

Board of Governors of the Federal Reserve System (US), Federal Funds Effective Rate [FEDFUNDS], retrieved from FRED, Federal Reserve Bank of St. Louis; S&P Dow Jones Indices LLC, S&P 500 [SP500], retrieved from FRED, Federal Reserve Bank of St. Louis, October 17, 2022 (data available through September 1, 2022)

Be careful out there!

Full disclosure: short SPY put spread


Why the Fed Won’t Read Cathie Wood’s Open Letter

A Letter or A Plea?

ARK Invest’s Cathie Wood has opposed the Federal Reverse since at least the time the U.S. central bank first hiked rates above zero. Just three weeks after the Fed’s first interest rate hike, with more promised, Wood warned the Fed was making a mistake. On April 2nd, Wood jumped on a market signal from the inversion of the yield curve to underline the point.

The inversion barely lasted 2 days. The yield curve quickly “reverted” for the next 3 months and threw wrenches into the prognostications of a Wall Street looking for a recession to stop the Fed in its tracks. The yield curve inverted again in early July and has yet to look back. Yet, the Fed has become increasingly hawkish even in the face of this traditional signal of a recession. The Fed’s resolution was epitomized by a curt speech at Jackson Hole where Chair Jay Powell stood resolute on the Fed’s inflation fighting mantra.

Source: Board of Governors of the Federal Reserve System (US), Market Yield on U.S. Treasury Securities at 10-Year Constant Maturity, Quoted on an Investment Basis [DGS10], retrieved from FRED, Federal Reserve Bank of St. Louis; October 10, 2022.

So it is no surprise that Wood recently opened a new salvo in her campaign against the Fed’s monetary policy by writing an “open letter to the Fed” to extend her latest criticism in her videocast “In the Know.” In this letter, Wood warns that the Fed is overly focused on lagging indicators from inflation and employment and cannot see the “deflationary bust” that awaits the other side of its aggressive monetary tightening. In many ways, a deflationary bust has already occurred in financial markets. For example, Wood’s flagship fund The ARK Innovation ETF (ARKK) is just a “day’s trade” away from returning to its pandemic lows. Those sudden March, 2020 lows came on the heels of an economic and market crash that was full-force deflation until monetary and fiscal stimulus saved the day.

ARK Innovation ETF (ARKK) long ago lost all its pandemic era gains and how looks set to return to its pandemic crash levels. (Source:

A Deflation Is Already Here

In other words, the deflation that Wood fears has already unfolded in certain financial markets. That pain is felt by anyone invested in the stock market. That pain runs even deeper for those speculating in the companies uncomfortably jostling around in the collection of ARK funds. However, Wood’s letter does not point to prices in her funds. Instead, the letter relies on a series of economic readings showing peak prices and subsequent declines for gold, silver, lumber, iron ore, DRAM, shipping, copper, corn, oil, and container board. The letter points out the ballooning inventories at major U.S. retailers and elements of employment data that show the first signs of a hot labor market finally beginning to cool.

All this complaining across Wall Street and all these data of course beg the question: why is the Fed ignoring it all? However, I think this question is misplaced. For example, Mary Daly, head of the San Francisco Fed, insisted that the Fed is forward looking. She even scolded the market is wrong in expecting rate cuts in 2023. The Fed has hundreds of economists on staff, including the ones who help to curate the charts from the St Louis Fed that I used to show the yield curve inversion. They know everything and more than the economists who get all the attention in the media. So I think it is a stretch to conclude that the Fed has no idea what is going on.

Why the Fed Won’t Read Cathie Wood’s Letter: Speculating on the Fed’s (Unstated) Strategy

Instead, I look to the larger, strategic context. The Fed kept rates too low for too long: the mania in the housing market and stratospheric valuations of profitless companies (again, see the ARK Funds) are sufficient evidence that the Fed should have started the journey toward normalization earlier. Moreover, the Fed has a massive $9 trillion dollar balance sheet that represents a considerable share of the $20 trillion U.S. economy. My guess is the Fed is not hearing the whispers of the famous inflation fighter, former Fed Chair Paul Volcker. Instead, the Fed recognizes the layers of distortions it helped to create in the economy, and it desperately wants to hit the reset button. From the purview of neutral to slightly restrictive policy, it can THEN observe the impact and assess whether the economy can sustain the resulting damage. I also guess that the Fed fully recognizes that the very minute markets sniff a peak in monetary tightening, speculative forces will roar away. Just watch what happens to the ARK Funds in that moment. Indeed, when Wood expected the Fed to cry uncle in July, she anticipated a vindicating resurgence in the ARK Funds.

In this environment where financial markets have become accustomed to easy money and have little experience dealing with inflationary pressures, the Fed is forced to err on the side of being aggressively hawkish as long as it dares possible. The Fed needs to make sure that when the time comes to pause and observe, little to no inflationary embers are left smoldering, ready to reignite with the giddy anticipation of easy money days to come again. As long as employment remains robust and resilient, the Fed can maintain political support for its actions even as support from market participants plummets. The rush to get to neutral or past neutral is likely exactly because the employment window cannot remain open to the Fed for an extended period. The Fed’s actions suggest a strategy for finishing hikes by the time the labor market’s weakness is obvious through an uptrend in the unemployment rate. The Fed has shown itself unmoved by losses in financial markets. So, pundits can throw all the macroeconomic tomatoes they want, the Fed is in over-correction mode for now.

Clinging to the ARK

When the bottom fell out of the ARK Funds, I updated my technical assessment and trading strategy on each of the major funds. I continue to think that the technicals are much more important than the fundamentals here. While the inverse correlation between interest rates and ARK performance is fundamental (surely much to Wood’s chagrin), the technicals of trend-following are sufficient for making trades. At some point, rates WILL peak. I contend the technicals (of trading on extremes) will actually become even MORE important then. Who knows what will be left standing in the ARK funds by that point…

Be careful out there!

Full disclosure: long ARK

Fed’s Daly: The Market Is Wrong About A Hump in 2023 Fed Rates

The Federal Reserve board governors continue to stay on message, reminding the market over and over about its serious intention to fight inflation. San Francisco President Mary Daly has been particularly articulate on the Fed’s plan and what likely lies ahead. In an interview with Bloomberg Finance today, Daly informed financial markets that they are “wrong” to project what the interviewr called a “hump” in rate expectations. This hump is a peak sometime in 2023 with rate cuts to follow soon after. The current view from CME FedWatch has rates peaking from the February through June, 2023 meetings with a rate cut in July.

A peak in the Fed rate from February through June, 2023 and an easing cycle starting with a single rate cut in July.

Daly’s steadfast perspective is important to remember every time the stock market rallies in anticipation of peak inflation and/or a “Fed pivot.” Indeed, Daly warned that the Fed needs to be prepared for inflation to be more persistent than expected. For context, Daly was one who was unwilling to predict peak inflation ahead of what turned out to be the “CPI shocker” that delivered a surprise of higher core inflation. Part of Daly’s persistence comes from what she and the Fed see as inflation’s greater potential for economic harm than the short-term consequences of normalizing monetary policy. Daly noted that over two years real wages have fallen 9%. She even shared an anecdote of a worker who told her about how he “loses” money when he goes to buy something with his earnings (an anecdote that speaks to nominal wages failing to keep up with nominal increases in prices).

Other interesting nuggets from the interview:

  • Rates are probably now around the neutral rate, and the Fed needs to get slightly restrictive.
  • The length of time rates stay neutral (or slightly restrictive) is more important than the specific level.
  • 50% of today’s inflation is driven by demand (thus justifying the Fed’s desire to get slightly above neutral), 50% from supply.
  • Daly refused to take the bait on the question of whether the Fed was purposely trying to induce a recession, trying to force losses on the stock market, or intent on hiking rates until something breaks.
  • Daly insisted the Fed is forward-looking and recognizes lagging indicators of inflation.
  • Daly pushed back on the notion the Fed needs to coordinate with global central banks. She insisted that the Fed must stick to its domestic dual mandate.

While the signs a few months ago were clear from commodity prices that the Fed’s actions were impacting inflation, the recent strength in oil threatens to rekindle inflation fears from the average person. For example, gas prices look like they are already done declining. The United States Gasoline Fund, LP (UGA) broke out today. UGA looks like it double-bottomed in September.

The recent downtrend in United States Gasoline Fund, LP (UGA) came to an end this week with a powerful breakout above 50 and 200DMA resistance.

Similarly, diversified commodities producer BHP Group (BHP) looks like it is holding a bottom in place since late last year.

BHP Group (BHP) has so far held its lows from a year ago. While upside may be limited, BHP also looks like it is done going down for now.

If these bottoms are indicative of what is ahead, then any soft readings in the near-term inflation numbers could be, well, transitory… (tongue-in-cheek intended!)

Be careful out there!

Full disclosure: long BHP