Fed’s Bostic: Still Comfortable Leaning Into Tight Labor Markets

Posted: May 25, 2023 | Author: Dr. Duru | Filed under: Currencies, Economy, Monetary Policy | Tags: DXY, DXY0, Fed Fund Futures, Federal Reserve, initial claims, Raphael Bostic, technical analysis, U.S. dollar | Leave a comment

I have argued for a while that as long as the labor market remains tight with low unemployment, the Federal Reserve will press as far as it dares on its cycle of monetary tightening. Raphael Bostic, CEO of the Atlanta Federal Reserve (and currently a non-voting member of the Federal Open Market Committee), confirmed that strategy during a recent interview with Marketplace.

Don’t Come Crying to the Fed Anytime Soon

Bostic definitively stated that the Fed is so determined to press against inflation that it will likely turn a deaf ear to those who will ask for easier monetary conditions the moment the labor market delivers bad news. Emphasis mine:

“You know, as we get further into inflation getting, closer to our target, I’m expecting we’re going to see stresses in labor markets. We’ve not really seen that. And when that starts to happen, people are going to be looking to us to try to do something about that as well, and maybe turn away from our focus on inflation. But we can’t do that, because failing in getting the inflation back to the 2% target will be much more problematic for the economy. And so as people start to call out for action to provide relief in labor markets, I think what we’re going to have to do is just stay laser focused on the fact that, you know, our employment mandate goal, we are very, very close to that right now. And we’re not close to that in inflation. So we have to stay focused on inflation.”

The bad news for the labor market has been long anticipated and stubbornly absent for the people who keep expecting a recession at every turn of the calendar. This “lagging indicator” of economic health just keeps chugging along. Even a recent uptick in initial unemployment claims above 240,000 fizzled out before the “I told you so’s” could drape the economic headlines. The 251,000 in weekly initial claims from January, 2022 stands as the latest high. For now, initial claims continues to tell the same message week after week after week: the Fed has room to hike if inflation remains an issue. Rate cuts are certainly nowhere on the horizon from this vantage point.

Source: U.S. Employment and Training Administration, Initial Claims [ICSA], retrieved from FRED, Federal Reserve Bank of St. Louis; May 25, 2023.

Given this data and Bostic’s determination to ignore anyone who wants the Fed to cut rates into an inflationary environment, I understand Bostic’s best guess target for rate cuts set a year or more out from now.

“My best case is that we won’t be thinking about a cut until well into 2024. And, you know, inflation is just double what our target is by just about every measure. I don’t see scenarios where the economy is going to evolve in a way such that inflation gets close enough to our target where we might contemplate any kind of cut.”

As of the time of writing, Fed fund futures have acquiesced to the likelihood of another rate hike by July. However, they still eagerly anticipate rate cuts as soon as November. By the time Bostic guesses the Fed will think about cuts, the futures think the Fed will have 6 or 7 rate cuts in the books. The persistently wide gulf between Fed and market expectations on rate policy remains one of the more remarkable features of today’s financial markets.

Fresh Wind for the U.S. Dollar

The market’s push for another rate hike by July has helped the U.S. dollar regain momentum. Strength particularly against the euro and the Japanese yen has the dollar index (DXY) bouncing off its lows for the year. I am riding this momentum as long as it holds up. If the rally continues from here, I expect fresh resistance at the year’s high which should also coincide at the time with critical resistance from the 200-day moving average (DMA) (the bluish line below).

Source: TradingView.com

Be careful out there!

Full disclosure: net long the U.S. dollar

A Golden Inflation Conundrum

Posted: April 17, 2023 | Author: Dr. Duru | Filed under: commodities, CPI, gold, Monetary Policy, PPI | Tags: abandoned baby top, Christopher J. Waller, Consumer Price Index, CPI, Federal Reserve, gld, inflation expectations, Monetary Policy, PPI, Producer Price Index, SPDR Gold Shares, technical analysis, University of Michigan surveys of consumers | Leave a comment

Last week, SPDR Gold Shares (GLD) rallied on weak inflation news and pulled back on strong inflation news. The gap up in GLD followed by a gap down created the dreaded “abandoned baby top.” This technical pattern typically signals the end of a rally. What gives with this golden inflation conundrum?

SPDR Gold Shares (GLD) printed a technical topping pattern amid mixed inflation news, but it is trying to hold uptrending support at the 20-day moving average (DMA)

The Conundrum

The current inflationary cycle could be ending, at least in North America. For example, the Bank of Canada (BoC) showed inflation data with a steeply descending trend ending with a near perfect landing at the Bank’s 2% target in late 2024.

Here in the U.S. plenty of pundits have declared inflation a non-threat ever since the Federal Reserve finally got serious about it. Cathie Wood has been one popular critic of the Fed’s inflation concerns. The disbelievers received more confirming evidence when the latest producer price index told a disinflationary story. A slightly weaker than expected inflation reading from the March Producer Price Index (PPI) generated cheer in stocks given the implication for looser monetary policy. Since producer prices sit upstream from final goods prices, PPI can be a leading indicator of future prices.

Gold also celebrated the soft inflation numbers; GLD gained 1.4%. This reaction represents the upside of the golden inflation conundrum. Gold bugs suspect that the seeds of inflationary pressures remain well-grounded in the economy. I agree with them. A relaxed Fed is a potential catalyst for rewatering the garden of growing prices, especially if labor markets remain tight. Thus, the prospect of a relaxed Fed supports higher gold prices.

The downside of the golden inflation conundrum can come on stronger inflation signals because they support an aggressive, inflation-fighting Fed. GLD went into retreat in the wake of a surprising surge in consumer expectations for inflation next year from 3.6% in March to 4.6% in April. This reading from the University of Michigan’s surveys of consumers was last this high in November, 2022. Even if this move coincided with the jump in gas prices, surges in inflation expectations are sure to encourage the Fed to stay on message. As it happened, the market got a timely dose of messaging from Governor Christopher J. Waller the same day.

The Fed Stays On Message

In the wake of the economic data, Governor Christopher J. Waller spoke at the Graybar National Training Conference in San Antonio, Texas. Waller reiterated the all too familiar refrain “inflation remains much too high.” He provided the following cautionary assessment of inflation (emphasis mine):

“Inflation moderated in the second half of 2022, but that progress more or less stalled toward the end of the year…On April 12, we got consumer price index (CPI) inflation data for March, and it was another month of mixed news…Core inflation, which strips out food and energy prices, is a good guide to future inflation, and that measure came in at around 0.4 percent in March, which translates to an annual rate of 4.6 percent if it were to persist. It was the fourth month in a row with core inflation at 0.4 percent or higher. Since December of 2021, core inflation has basically moved sideways with no apparent downward movement. So, despite some encouraging news on a slowing in housing costs, core inflation does not show much improvement and remains far above our 2 percent inflation target.

Whether you measure inflation using the CPI or the Fed’s preferred measure of personal consumption expenditures, it is still much too high and so my job is not done. I interpret these data as indicating that we haven’t made much progress on our inflation goal, which leaves me at about the same place on the economic outlook that I was at the last FOMC meeting, and on the same path for monetary policy. Because financial conditions have not significantly tightened, the labor market continues to be strong and quite tight, and inflation is far above target, so monetary policy needs to be tightened further. How much further will depend on incoming data on inflation, the real economy, and the extent of tightening credit conditions.”

With the Fed’s next decision on monetary policy just two weeks away, Waller’s words suggest that the Fed could raise rates yet again. The odds are low of getting a disinflationary signal strong enough to counter Waller’s observations. Thus, I think GLD will struggle to invalidate the technical topping pattern for the time-being.

The Trade

The golden inflation conundrum leaves GLD in a contrary place. In the short-term, GLD’s best chances lie with soft inflation numbers. Indeed, GLD bottomed shortly after the market bottomed in October when market participants concluded that inflation had finally peaked. Inflation’s peak does not equal the Fed’s inflation target; the Fed has gone to great lengths to issue these reminders. Yet, beyond day-to-day volatility, the market has overall chosen to fight the Fed’s hawkishness ever since October. Volatility is even back to levels last seen at the start of trading in 2022 despite the linger crisis in regional banking.

Where volatility is poorly positioned, GLD is well-positioned. From the looming battle over the U.S. debt ceiling to the prospect of the Fed standing down later this year to geo-political risks, there are enough reasons to stay bullish on GLD. I am back to trading around my core position. I took profits on half my call spreads last week. My remaining half is set to expire in September. I want plenty of runway for the gold-positive catalysts to work their way through the golden inflation conundrum.

Be careful out there!

Full disclosure: long GLD shares and call spread

Don’t Blame the Fed: The Fed Gives Us What We Want

Posted: March 21, 2023 | Author: Dr. Duru | Filed under: commodities, Economy, gold | Tags: CME FedWatch Tool, Fed balance sheet, Fed Fund Futures, Federal Reserve, gold, Jim Chanos, Monetary Policy, National Financial Conditions Index, NFCI, Panic of 2023, PHYS, SBNY, Signature Bank, Silicon Valley Bank, Sprott Physical Gold Trust ETV, SVB, SVB Financial Group | 2 Comments

The Fed’s risk management strategy was ostensibly designed to keep pushing rates higher until the Fed slayed the inflation dragon or something in the economy forced it to stand down, whichever came first. Unfortunately for the Fed, the dice rolled in favor of the latter. Instead of a soft landing or even a mild recession, bank failures landed on the Fed’s collective lap in the form of SVB Financial Group (SVB), the parent company of Silicon Valley Bank, and Signature Bank (SBNY). It is very easy to blame the Fed for this mess (today’s chorus is pretty emphatic on this point). However, the problems in Silicon Valley Bank (SVB), which was the strongest catalyst for the Panic of 2023, started well before the Fed belatedly decided to start tightening monetary policy. ABC News confirmed reports from the New York Times and the Wall Street Journal on the following timeline:

Starting in 2019: The Federal Reserve warned Silicon Valley Bank about risks in the bank.
2021: “The Fed identified significant vulnerabilities in the bank’s containment of risk, but the bank did not rectify the weaknesses.” Ironically enough, one of the six fines issued to SVB included “a note on the bank’s failure to retain enough accessible cash for a potential downturn.”
July, 2022: a full supervisory review revealed the bank as “deficient for governance and controls.”
Fall 2022: the Federal Reserve of San Francisco met with “top officials at the bank to address the lack of accessible cash and the potential risks posed by rising interest rates.”

In other words, tight monetary policy was not the root problem of the bank’s problems. Tighter monetary conditions finally forced the issue of disciplining the bank. Tighter monetary policy is supposed to mop up excesses in the economy, and Silicon Valley Bank is starting to look like yet one more egregious example of the excess enabled by the prior era of easy money. It will be interesting to see whether the Fed’s review of its regulatory supervision includes claims that it lacked the authority to force SVB to change its ways.

The Fed Gives Us What We Want

Regardless, as I continue to see blame heaped on the Fed for this latest episode of financial instability, I have surprisingly adopted a more sympathetic view of the Fed’s work. The Federal Reserve has a near impossible job. It seems every major change in monetary policy sets the seeds for the next financial drama. Every financial drama raises the Fed’s prominence yet higher as a centralized economic planner, never able to return to the background of a free market. The Fed now must constantly tinker with interest rates with no clear terminal point. In particular, the economy has set up the Fed to bias towards keeping monetary policy as accommodative as possible for as long as possible. The Fed gives us what we want: policy that supports higher asset prices from stocks to real estate.

The index of financial conditions, as measured by the National Financial Conditions Index (NFCI), since the Great Financial Crisis (GFC) shows extended periods of very easy financial conditions. It is remarkable how little time the economy has been stuck with a positive index, or even a component on the positive side of danger…even in the aftermath of the economic shutdowns from the pandemic.

The Fed’s balance sheet is an even better example of how the Fed gives us what we want in the form of accommodative monetary policy. The Fed was never able to reduce its balance sheet after the GFC. The current tightening cycle barely put a dent in the Fed’s balance sheet. I have a sneaking suspicion that the Fed will never get its balance sheet back to pre-pandemic levels either. Note how the balance sheet ticked up as of last Wednesday in the wake of the rescue programs rolled out to backstop failing banks.

Board of Governors of the Federal Reserve System (US), Assets: Total Assets: Total Assets: Wednesday Level [RESPPANWW], retrieved from FRED, Federal Reserve Bank of St. Louis, March 21, 2023.

Before the GFC, this kind of balance sheet expansion was considered unthinkable. Surely, such a growth in the balance sheet would cause dangerous inflation levels. Given the on-going duration and size of this expansion, I am guessing economic theories will slowly but surely normalize the existence of this balance sheet. Yet, the longer this largesse continues, the more the economy will depend on sustaining these high levels. Thus, the economy will remain vulnerable to instability whenever economic conditions force the Fed into tightening policy. (Recall how the previous tightening cycle moved at a snail’s pace but still eventually forced the entry of a “Plunge Protection Team” to put a floor under the stock market).

What We Want Is Not Free

In a July, 2022 interview on Bloomberg’s Odd Lots (starting at the 14:35 point), famous short-seller Jim Chanos presciently claimed (emphasis mine):

“The one thing people are not prepared for is interest rates resetting meaningfully higher…It just hasn’t happened in most investors’ lifetimes…the idea that actually interest rates are not going to be 2 or 3% for the foreseeable future is going to be hard for a lot of investors to deal with. If we go back to what I would think are more reasonable rates based on what we’re seeing in the economy…this market will not be able to handle 5 or 6% 10-year. It just won’t. So many business models that we look at are extremely low return on invested capital because capital has been so plentiful for the past 12 years.”

The subtext here is that the Fed’s bias has been to leave monetary policy as accommodative as possible for as long as possible. Deflation was the great imperative chasing the Fed into monetary corners. The response to the pandemic was the logical conclusion of this policy as the Fed decided it had the luxury to keep driving unemployment ever lower by holding rates lower for longer. The economy appeared to be in another era where liquidity and massive stimulus could be conjured up for free. The pandemic’s inflationary pulse eventually turned the tables. What we want can actually be quite costly.

Thus, the Fed finds itself in a new trap. I feel for the Fed, but I don’t blame them…we prefer easy money…and many eagerly await the Fed getting disciplined back into cooperation by the Panic of 2023. The Fed Fund futures suddenly expect a long string of rate cuts to follow peak rates in May. I sure hope inflation cooperates as well!

Source: CME FedWatch Tool as of March 21, 2023

A Golden Epilogue

Gold received a new burst of life thanks to the Panic of 2023. As soon as the Fed blinks, I expect gold to rally further. I am keeping the buy button close as we go into the next several decisions on monetary policy starting with March’s. The Sprott Physical Gold Trust ETV (PHYS) broke out to an 11-month high. Today’s 2.0% pullback from over-extended price action looks like it is setting up the next buying opportunity.

Source: TradingView.com

Be careful out there!

Full disclosure: long GLD

An Inflation Downtrend Quickly Evaporates

Posted: February 24, 2023 | Author: Dr. Duru | Filed under: Bond market, Economy | Tags: Federal Reserve, iShares 20+ Year Treasury Bond ETF, PCE, Personal Consumption Expenditures, S&P 500, SPY, technical analysis, TLT | Leave a comment

Some inflation analysts have enthusiastically contorted the inflation data to dismiss today’s inflation problem and/or conclude that inflation’s run came to an end months ago (since last year’s peak). One method of dismissal came in the form of a downtrend in the monthly change in the core Personal Consumption Expenditures (PCE) starting conveniently at the peak as far down as November’s relatively benign reading. (Alan Binder used a related method dividing inflation into different time periods). Suddenly, with two consecutive up months that inflation downtrend has evaporated. The mist leaves behind what essentially looks like a random walk in the land of higher for longer.

Source: U.S. Bureau of Economic Analysis, Personal Consumption Expenditures Excluding Food and Energy (Chain-Type Price Index) [PCEPILFE], retrieved from FRED, Federal Reserve Bank of St. Louis; February 24, 2023.

The chart above shows how the pandemic disrupted a serene post financial crisis range for monthly core PCE largely between 0.0% to 0.2%. Since PCE’s breakout two years ago (which the Fed ignored as transitory), core PCE has effectively settled into a higher range from 0.2% to 0.6%. Inflation may have indeed peaked, but it remains stubbornly high in the aggregate. The eagerly anticipated pre-pandemic serenity remains as elusive as ever.

Higher for longer inflation aligns with the Federal Reserve’s insistence on maintaining restrictive monetary policy higher for longer. The stock market may finally be catching on to the notion of higher for longer for inflation. When the core Consumer Price Index (CPI) came in hotter than expected in the previous week, the S&P 500 (SPY) wavered from intraday highs to lows and even increased the next day. Sellers took over the next 5 of 6 trading days with today’s 1.0% loss seemingly confirming a change in sentiment.

The S&P 500’s loss would have been worse except traders decided to defend support at the 200-day moving average (DMA) (the blue line above). This important trend line separates the index from more churn and a continuation of selling back down to the bear market line (20% down from the all-time high).

The bond market sniffed out the hotter inflation environment ahead of the stock market. Bond yields have steadily risen all month. For example, the iShares 20+ Year Treasury Bond ETF (TLT) is down 5.8% month-to-date (lower TLT means higher yields). The hot PCE brought an abrupt end to a 2-day relief rally in TLT.

Of course, the inflation story does not end here. The recent experience with inflation surprises suggests inflation will continue to confound the over-confident. A humbled Federal Reserve seems validated in taking a “risk management” approach to monetary policy in this haze of uncertainty. Still, if monthly core PCE takes a fresh drop next month, I am guessing a chorus will resume the inflation dismissals. If monthly core PCE continues higher from here, I will ring fresh alarm bells. I am watching the bond market’s next moves for potential clues. Moreover, I cannot wait to hear what the Federal Reserve and Chair Jerome Powell have to say about these developments in next month’s meeting!

Be careful out there!

Kashkari Acknowledges the Fed’s Inflation Miss. Will the Fed Catch Easing Financial Conditions?

Posted: January 30, 2023 | Author: Dr. Duru | Filed under: Automobiles, Bond market, Economy, Monetary Policy | Tags: Adjusted Financial Conditions Index, ANFCI, Federal Reserve, iShares 20+ Year Treasury Bond ETF, James Bullard, Neel Kashkari, TLT | 2 Comments

At the beginning of the year, Neel Kashkari, President of the Minneapolis Federal Reserve, wrote a revealing piece titled “Why We Missed On Inflation, and Implications for Monetary Policy Going Forward.” The article is a worthwhile (and bit-sized) piece since it may be the first and only time any member of the Fed has attempted to confront this topic head-on. Recall that it was June, 2021 when the Fed first acknowledged a surprising increase and persistence in inflation pressures. However, Chair Jerome Powell implied that the inflation problem would go away on its own accord. It was St. Louis Federal Reserve President and CEO who raised a truly hawkish alarm bell. His colleagues took a lot longer to get on board.

Kashkari’s Confessional

Kashkari sums up the Fed’s collective miss as coming from an over-reliance on traditional Phillips-curve models. These models failed the Fed for this economic cycle:

“In these workhorse models, it is very difficult to generate high inflation: Either we need to assume a very tight labor market combined with nonlinear effects, or we must assume an unanchoring of inflation expectations. That’s it. From what I can tell, our models seem ill-equipped to handle a fundamentally different source of inflation, specifically, in this case, surge pricing inflation.”

No wonder it is easy to maintain a deflationary mindset. The Philips-curve models are biased against inflationary pressures.

Refreshingly, Kashkari is not willing to accept economic shocks as an excuse for missing the seriousness of inflation in this economic cycle. Instead, he cautions that such dismissals impede learning. Moreover, he claims that even a crystal ball on inflation shocks would not have pushed the Philips-curve models to raise an inflation alarm. Since Kashkari makes this claim without evidence, I hope that someone in the Fed is working on a related white paper to advance learning on this topic.

Kashkari went on to observe that the Fed’s policy framework focuses on the labor market and inflation expectations: “If we can deepen our analytical capabilities surrounding other sources and channels of inflation, then we might be able to incorporate whatever lessons we learn into our policy framework going forward.” Yet, in April 2022, I summarized two Fed studies that identified housing as a key source of the inflation problem. At the time, I assume these studies helped guide the Fed’s determination to finally start hiking rates. I do not know how to reconcile these studies with Kashkari’s claim, but I hope he finds his way to this work at some point.

Kashkari concludes by standing firmly behind today’s monetary policy. Without a sense of irony, Kashkari defended the current monetary tightening by using wage pressures as his example.

“One may ask why tightening monetary policy is the right response to what I described as surge pricing inflation. Unfortunately, the initial surge in inflation is leading to broader inflationary pressures that the Federal Reserve must control. For example, nominal wage growth has grown to 5 percent or more, which is inconsistent with our 2 percent inflation target given recent trend productivity growth. Monetary policy is the appropriate tool to bring the labor market back into balance.”

Kashkari is also not interested in cutting rates anytime soon: “consider cutting rates only once we are convinced inflation is well on its way back down to 2 percent.” Seemingly like everyone else on the Fed, he fears the echoes from the 1970s warning that it is all too easy to declare a premature victory over inflation.

Easing Financial Conditions

If bond yields are any indication, the bond market stopped worrying about increasing inflation pressures back in October and November. For example, the iShares 20+ Year Treasury Bond ETF (TLT) not only bottomed but also it rallied 15.5% in just three months (TLT moves inversely to bond yields). Accordingly, I am eager to see whether the next announcement on monetary policy calls out the bond market for prematurely facilitating an easing in financial conditions.

The iShares 20+ Year Treasury Bond ETF (TLT) achieved a higher low at the end of December. It is close to a breakout above tis 200-day moving average (DMA) (the blue line above) which would usher in a new phase of easing of financial conditions. Is the Fed ready for that to happen? (Source: TradingView.com)

The Chicago Federal Reserve’s Adjusted Financial Conditions Index has been consistently easing since a cycle high in October.

Be careful out there!

Full disclosure: no positions

Did Alan Blinder Suggest the Fed Should Have Done Nothing About Inflation?

Posted: January 19, 2023 | Author: Dr. Duru | Filed under: Monetary Policy | Tags: Alan Blinder, Federal Reserve, Monetary Policy, PCE | 6 Comments

The Claim

Former Fed Governor and current Princeton Economics professor, Alan S. Blinder wrote an opinion piece in the Wall Street Journal that essentially implied the Federal Reserve need not have raised rates to battle inflation. In a piece with the click-worthy title “What if Inflation Suddenly Dropped and No One Noticed?“, Blinder makes the following claim:

“Was the rest of the stunning drop in inflation in 2022 due to the Fed’s interest-rate policy? Driving inflation down was certainly the central bank’s intent. But it defies credulity to think that interest-rate hikes that started only in March could have cut inflation appreciably by July. There is an argument that monetary policy works faster now than it used to—but not that fast.”

Blinder goes on to explain that relief from supply and energy shocks were the biggest drivers of plunging inflation. Going forward, he thinks that the current five month decline in inflation is “…still too short a time to declare victory,” but he gives no explanation as to why going forward further Fed rate hikes will matter for getting inflation down this last mile of the way. I would have expected Blinder to argue that the Fed has already over-corrected for inflation.

Chasing the Trend In Inflation

It is pretty well accepted that inflation peaked several months ago. However, when Blinder worries that “no one will notice” the drop in inflation, he is worried about the finer technical details of trends. He breaks out the difference between earlier and current inflation to show how the year-over-year rate blurs the story.

“…the CPI inflation rate over the past 12 months has been an alarming 7.1%. But the U.S. economy got there by averaging an appalling 10.6% annualized inflation rate over the first seven months and a mere 2.5% over the last five. The PCE price index tells a similar story, though a somewhat less dramatic one. The 5.5% inflation rate over the past 12 months came from a 7.8% rate over the first seven months followed by a 2.4% rate over the last five.”

Blinder acknowledges that using this more refined (I will call it less lagged) approach would have also warned the Fed much earlier about inflation in 2021. In fact, it was recent trends that made loud skeptics of the Fed’s reassurances about “transitory” inflation.

Regardless, there is little magic or revelation in this breakdown. Blinder is simply providing a more technical description of what happens when a metric that quantifies changes over time peaks: the earlier components of that measure are, on average, higher than the more current ones. The graph below of the PCE (personal consumption expenditures) excluding food and energy juxtaposes the monthly change (grey line and vertical axis on the left) in the PCE with the annual change (black line and vertical axis on the right) in the PCE.

Note how the pre-pandemic stability in the monthly change supported stability in the annual change of the PCE. The annual change started to rise once the monthly changes started to rise to higher levels post-pandemic. The annual change reached a new, higher stability after the monthly changes stopped rising. Now, the monthly changes are finally producing a higher frequency of much lower numbers. Thus, the annual change looks like it has finally peaked. Stare hard enough, and you can even see the early makings of a declining trend.

Blinder worries that no one may notice the sudden drop in inflation. However, I suspect plenty of people have noticed the decline. There is a healthy collection of Fed critics and related folks who think the Fed over-reached after its first rate hike last March or May who are twisting the numbers every possible way to make the case that the inflation problem died a few months ago and/or the Fed has taken interest rates far too high, too fast. Again, because inflation has apparently peaked, it is easy to fathom that more recent inflation pressures are milder than earlier inflation pressures.

Where Is the Policy Implication?

Blinder’s WSJ piece avoided giving direct advice on monetary policy. However, he gave more clues in an interview with Marketplace. At the very end of the discussion, Blinder essentially said that the Fed should stop now, but they cannot do so because market’s will prematurely ease:

“The Fed is in a very ticklish position. They can’t be as frank as I just was with you. I could say anything, and I don’t move markets. If Jay Powell sneezes, he moves markets. It is too early to declare victory over inflation, it’s only six months. And that’s what Jay Powell or any of the Fed people would say if you had them on the radio. But I say it’s six months. Six months is not a week, six months is not two months. This is not a trivial length of time. I think it might take a year of this or, say, another six months to convince the Fed to declare victory. They’re not about to declare victory yet.”

Note how his advice here directly contradicts his caution in the WSJ piece that the timeframe for the inflation decline is too short to support victory laps. No wonder monetary policy can be so confusing.

Moreover, the Fed has been very clear about the metric it uses for the 2% inflation target: a year-over-year change that is demonstrably sustainable. The Fed cannot declare victory because the target as previously defined still sits out in the future. To suddenly change the timeframe to inflation over the last X months would undermine Fed credibility even more than the retreat from the “transitory” episode.

Ironically, with the Fed already effectively programming itself to end rate hikes in March, Blinder’s technical examination could be nearly moot…at least without specific policy prescriptions.

Be careful out there!

Median CPI May Be A Window on Fed’s Inflation Caution

Posted: December 18, 2022 | Author: Dr. Duru | Filed under: Bond market, Economy, Monetary Policy | Tags: 16 percent trimmed-mean CPI, Federal Reserve, Federal Reserve Bank of Cleveland, iShares 20+ Year Treasury Bond ETF, Jerome Powell, median CPI, TLT | 1 Comment

Last week, the Federal Reserve disappointed markets once again with its refusal to acknowledge the market’s belief in the end of the inflation threat. The opening statement for December’s decision on monetary policy delivered the familiar refrain: “The Committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.” During the press conference, Chair Powell further emphasized that the Fed has yet to see substantial evidence that inflation will continue to come down in a sustained way. So while the Fed is slowing the pace of rate hikes, the Fed will continue hiking past the market’s peak rate expectations. Powell even rebuffed once again the notion that the Fed will cut rates next year. So if inflation has peaked, why is the Fed so “stubborn”? The dynamics in median CPI may be a window on the Fed’s inflation caution.

Every month, financial markets receive a bevy of inflation reports. The Federal Reserve watches all of them as is clear from the various research papers and metrics the various Federal Reserve banks produce. The Federal Reserve Bank of Cleveland produces a monthly report on the median CPI and the 16 percent trimmed-mean CPI. Per the definition provided with the report:

“Median CPI is the one-month inflation rate of the component whose expenditure weight is in the 50th percentile of price changes. 16 percent trimmed-mean CPI is a weighted average of one-month inflation rates of components whose expenditure weights fall below the 92nd percentile and above the 8th percentile of price changes.”

Why use the median CPI and the 16% trimmed-mean CPI? The Cleveland Fed explains: “By omitting outliers (small and large price changes) and focusing on the interior of the distribution of price changes, the median CPI and the 16 percent trimmed-mean CPI can provide a better signal of the underlying inflation trend than either the all-items CPI or the CPI excluding food and energy (also known as core CPI).”

This effective smoothing of the inflation dynamics produces a lag in the peak for inflation and shows almost no indication that inflation is ready to come down in the sustained fashion the Fed wants to see. In the chart below, the yellow line is the median CPI, and the greyish blue line is the 16% trimmed-mean CPI. For November, the order from top to bottom is the (headline) CPI, median CPI, 16% trimmed-mean CPI, and the core CPI.

The trend is NOT yet down. If these were stock charts, I would even argue an uptrend remains in place.

The 16% trimmed-mean CPI looks like it has likely peaked, but the topping pattern lacks the double-topping that makes the peak in core CPI look so convincing. The median CPI is the worst news for those who think the inflation threat is already over: this measure is just now plateauing after streaking straight upward since late last year. Sure, there are all sorts of forward-looking measures that the Fed sees as confirming a peak in inflation, but there is little saying the inflationary pressures are going to come down sufficiently and conclusively. The Fed’s risk management framework thus mandates that the Fed proceed with caution. The magnitude of decline that mollifies the Fed remains anyone’s guess. Meanwhile, interest rates are still fighting the Fed and likely more focused on the prospects for a 2023 recession.

The iShares 20+ Year Treasury Bond ETF (TLT) is hovering at levels last seen three months ago. TLT looks like it bottomed out in October/November. Source: TradingView.com

Be careful out there!

Full disclosure: no related positions

The Fed Plants A Flag On Peak Inflation and An Economic Soft Landing

Posted: December 3, 2022 | Author: Dr. Duru | Filed under: Bond market, Economy, Jobs, Monetary Policy | Tags: federal funds rate, Federal Reserve, inverted yield curve, Monetary Policy, proxy funds rate, recession, S&P 500, SPY | 6 Comments

Robert G. Valletta, associate director of research and senior VP at the SF Fed, planted a flag on peak inflation and an economic soft landing in a recent economic research blog post. Valetta provided data suggesting that inflation is finally on a sustained path lower alongside increased risks for a mild recession. The blog post is not an official statement from the Federal Reserve Board of Governors, but the work is a powerful message nonetheless.

Valetta declared “recent data suggest that inflation may have peaked.” The latest inflation projection shows a gradual decline toward the Fed’s 2% average goal around 2025 or 2026. Valetta cautions that “repeated upside surprises” to inflation mean that “the risks to this forecast [are] weighted to the upside.” In other words, we should expect the Federal Reserve to keep its interest rate higher for longer in order to ensure inflation’s glide path stays pointed downward. The graph below shows the recent peak and successive higher forecasts for inflation since March.

After on-going upside revisions, PCE core price inflation is now expected to approach the 2% target somewhere around 2025. (Source: Federal Reserve Bank of San Francisco)

The cost of peaking inflation is slower growth. Valetta expects “growth to remain well below trend this year and next year before converging back to trend in 2025.” Conveniently, that return to trend occurs just as inflation returns to the Fed’s target. Most importantly, Valetta points to a mere one percentage point increase in unemployment “through 2024.” This expectation means that the onset of a recession next year will create a mild economic slowdown. Today’s unemployment rate is still near the historic low of 3.5%. Unemployment below 5% is surprisingly low for a recessionary environment. The high job vacancy rate softens the economic blow of slowing growth as there is plenty of room to cool off labor demand without disrupting the labor market.

Valetta acknowledged that the inversion of the yield curve suggests that odds are high for a recession: “such yield curve inversions have proven historically to be reliable predictors of recessions over the subsequent 12 months. After some divergence earlier this year, two leading measures of the yield spread have now both become inverted.” However, Valetta does not want readers to decide that a recession is a foregone conclusion: “their predictions come with substantial statistical uncertainty, however, and are not definitive indications that a recession is looming.”

Inverted yield curves have preceded recessions since the late 1980s. (Source: Federal Reserve Bank of San Francisco)

The Fed’s success in fighting inflation has come from a “proxy funds rate” that is much higher than the effective funds rate. According to the SF Fed, “this measure uses public and private borrowing rates and spreads to infer the broader stance of monetary policy.” The gap between the proxy and effective rate is higher than ever. No wonder Fed Chair Jerome Powell can so comfortably reiterate that the Fed can now slow the pace of rate hikes.

The proxy funds rate is over two percentage points higher than the effective federal funds rates.

With peak inflation finally here, traders and investors should focus on how long the Fed intends to keep a restrictive stance on monetary policy. Given the extended period over which the Fed expects above target inflation, monetary policy should remain restrictive for longer than the market currently expects. In turn, the implication for the stock market of restrictive policy and below trend growth means valuations must come down further and cap upside in market returns for 2023 and perhaps 2024. Time will tell of course.

The S&P 500 (SPY) is out of bear market territory and now trying to fight its way through restrictive monetary policy.

Be careful out there!

Stock Market Loves Powell Moving from “Keep At It” to “Stay the Course” On Fighting Inflation

Posted: December 1, 2022 | Author: Dr. Duru | Filed under: Bond market, Economy, Jobs, Monetary Policy | Tags: Brookings Institution, Fed Fund Futures, Federal Reserve, Jerome Powell, Monetary Policy, S&P 500, SPY | 5 Comments

When Federal Reserve Chair tersely spoke at Jackson Hole on August 26th, he sent a chill through financial markets. Taking on the toughest inflation-fighting tone he could muster, Powell concluded by proclaiming “we will keep at it until we are confident the job is done.” The S&P 500 (SPY) promptly dropped 3.4% on the day. The message was so harsh that it almost took two months for the stock market to bottom out. Fast-forward to Powell’s speech November 30th titled “Inflation and the Labor Market” at the Hutchins Center on Fiscal and Monetary Policy, Brookings Institution in Washington, D.C. Powell concluded by proclaiming “we will stay the course until the job is done.” The S&P 500 promptly rallied 3.1% on the day. The move was bullish enough to close the index above its 200-day moving average (DMA) for the first time in almost 8 months. The S&P 500 also closed above the May, 2021 low. Something about the difference between “keep at it” and “stay the course” significantly mattered to traders!

The S&P 500 (SPY) rallied enough to punch through two important resistance levels. The cumulative losses from Jackson Hole are now almost reversed. (Source: TradingView.com)

If not for the stock market’s reaction, I would have interpreted Powell’s speech to land somewhere between hawkish as ever and no new information. In fact, there were several key points from the speech which should have told the market the Fed is as serious as ever about sustaining an extended fight against inflation (the following are direct quotes unless otherwise indicated; particularly important quotes in bold):

It will take substantially more evidence to give comfort that inflation is actually declining. By any standard, inflation remains much too high.
So when will inflation come down? I could answer this question by pointing to the inflation forecasts of private-sector forecasters or of FOMC participant…But forecasts have been predicting just such…a decline for more than a year, while inflation has moved stubbornly sideways.
It seems to me likely that the ultimate level of rates will need to be somewhat higher than thought at the time of the September meeting and Summary of Economic Projections. (a reiteration from the November monetary policy meeting)
Restoring [supply and demand] balance is likely to require a sustained period of below-trend growth. (another reiteration)
Despite the tighter policy and slower growth over the past year, we have not seen clear progress on slowing inflation.
It is far too early to declare goods inflation vanquished, but if current trends continue, goods prices should begin to exert downward pressure on overall inflation in coming months. (the stock market must have focused on this claim)
As long as new lease inflation keeps falling, we would expect housing services inflation to begin falling sometime next year. Indeed, a decline in this inflation underlies most forecasts of declining inflation. (in other words, this claim is old news)
We can see that a significant and persistent labor supply shortfall opened up during the pandemic—a shortfall that appears unlikely to fully close anytime soon. (the stock market clearly did not hear this)
The labor market, which is especially important for inflation in core services ex housing, shows only tentative signs of rebalancing, and wage growth remains well above levels that would be consistent with 2 percent inflation over time. (in other words the job market is at risk of sustaining high rates of inflation)
Despite some promising developments, we have a long way to go in restoring price stability.
It makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down. The time for moderating the pace of rate increases may come as soon as the December meeting. (this is another reiteration, but the stock market seemed to treat this as welcome new news)

If the Fed Fund futures market reversed course and priced in lower peak rates, the stock market’s sudden burst of enthusiasm could have made more sense. However, futures speculators just shifted out the peak 5.00%-5.25% range by one meeting, from March, 2023 to May, 2023. The market did move up the schedule for the first rate cut and ended the year at 25 basis points lower. However, note well that during the Q&A Powell reiterated a warning about the market’s expectations for quick rate cuts: “Cutting rates is not something we want to do soon. That is why we’re slowing down.”

Fed Fund futures market peaked rates at the March, 2023 meeting ahead of Powell’s speech (source: CME FedWatch tool)

Fed Fund futures market peaked rates at the May, 2023 meeting after Powell’s speech and moved the first rate cut up by 5 months (source: CME FedWatch tool)

The day’s rally in the stock market is one of those many times to ignore contrary fundamental assessments and pay attention to what the market thinks. If buyers follow through with the 200DMA breakout on the S&P 500, I will assume seasonal tailwinds are in full flight. Absent any shocks, the market could then rally all the way into the Fed’s December 14th pronouncement on monetary policy. That event will give Powell a fresh chance to redirect financial markets if financial conditions loosen up too much by then. Maybe Powell will have to reiterate how the Fed will “keep at it” instead of “staying the course.”

The Q&A of the Brookings Institution session mainly reiterated points from the speech. There were two points that stirred my interest for future reference.

First of all, Powell actually admitted that the housing market was in a bubble. The conditions he described were easily observable at the time: “coming out of the pandemic, rates were very low, people wanted to buy houses, get out of the cities and move to the suburbs. You had a housing bubble. Had prices going up that were very unsustainable levels, and overheating…” However, of course, the Fed did not dare say the “B” word in the middle of the mania. Powell did not offer any thought on whether the bubble could have been moderated by hiking rates sooner…or at least jawbone about the bubble.

Secondly, Powell mentioned one regret from the 2020 policy framework reset that he mentioned almost as a footnote. Powell indicated that he would not repeat the mistake of relying on a long history of low inflation as a basis for making policy. At the reset, Powell communicated that the Fed would not “lift off” (start hiking rates) until it “saw both maximum employment and price stability.” The stock market soared on this news as it correctly interpreted the change as a Fed more tolerant of a higher range in inflation. Powell admitted that commitment “made us under-estimate tail risk.”

I soundly criticized this pronouncement at 2020’s Jackson Hole. While Powell insisted this mistake has nothing to do with today’s inflation, I continue to insist that this commitment made the Fed slow to respond to rising and then realized inflation risks. Members of the Fed have also dismissed the notion that starting rate hikes a little earlier would have made a material difference in the inflation landscape. We will never know the counterfactual of course. Still, I feel somewhat vindicated that the Fed has taken note of its policy mistake (and prior deflationary bias) and learned some lessons.

Be careful out there!

Appendix: Notes from the Q&A session

Wage increases are going to be a core part of the inflation story going forward.

The labor market has a real supply imbalance

For most workers, wage increases are being eaten up by inflation. Need price stability to get real wage increases.

We assumed that the natural rate of unemployment had gone higher during the pandemic. It’s very hard to pin down where it is when there is a massive disruption.

Used to be able to look through supply shocks. But if we have repeated shocks, it changes things. What are the implications if true? Very hard to know the answers. We tend to think things will return to where they were naturally, but that’s not happening.

Need to be humble and skeptical about inflation forecasts for some time, calls for a risk management framework. If you are waiting for actual evidence for inflation coming down, it is possible to over-tighten. Slowing down is a good way of balancing the risks.

Very few professional forecasters have gotten inflation right.

There isn’t any one summary statistic to determine when policy is sufficiently restrictive. We monitor the tightening of financial conditions (which happens based on expectations). We also look at the effect of these conditions on the economy. Look at the entire rate curve. For significantly positive real rates along the entire curve. Forward inflation expectations reflect confidence in the Fed getting inflation down to 2%. Look at exchange rates, asset prices. Put some weight on these things.

How do you know when you can stop shrinking the balance sheet? This has already been described in a document. We’re in an ample reserves regime. General changes will not impact the funds rate. Will allow reserves to decline until somewhat above where we think is scarcity. Hold the balance sheet constant….. The demand for reserves is not stable. It’s a public benefit to have plenty of liquidity.

Question: August, 2020 announced new flexible inflation targeting framework. Anything in that we should be rethinking. Answer: We will do another review in 2026 or 2026. We implemented through guidance of various kinds. Put in strong guidance because there were a lot doubters that we could ever achieve 2%. Neither did we know. One piece of guidance we wouldn’t do again (it doesn’t have anything to do with the inflation we are currently seeing): we wouldn’t lift off until see saw both maximum employment and price stability. It made us under-estimate tail risk. Remember 25 years of low inflation, inflation just didn’t seem likely.

Cutting rates is not something we want to do soon. That is why we’re slowing down.

It’s not reasonable to expect we get back to the labor force participation in 2020 before the pandemic. But I wouldn’t rule it out. It’s been disappoint and surprising how little we’ve gained back.

We have to assume that for now most of the labor force balancing has to come on the demand side. By slowing job growth, not putting people out of work.

At what point do people ask for more wages because they aren’t keeping up with inflation. Don’t know when that happens, but if it does, you’re in trouble. Labor shortage is not going away anytime soon.

Coming out of the pandemic, rates were very low, people wanted to buy houses, get out of the cities and move to the suburbs, You had a housing bubble. Had prices going up that were very unsustainable levels, and overheating, now the housing market is coming out the other side of that. We have a built-up country, we have zoning, it’s hard to get homes built to meet demand

Full disclosure: long SPY call spread

Inflation Expectations and Inflationary Psychology

Posted: October 17, 2022 | Author: Dr. Duru | Filed under: Central bank, Economy | Tags: fed funds rate, Federal Reserve, inflation expectations, interest rate, Monetary Policy, Richard Corbin, S&P 500, SPY, University of Michigan surveys of consumers | 1 Comment

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 wit h 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

Posted: October 11, 2022 | Author: Dr. Duru | Filed under: Bond market, Central bank, Economy, Monetary Policy | Tags: ARK Innovation ETF, ARKK, Cathie Wood, deflation, Federal Reserve, inverted yield curve, Monetary Policy | 2 Comments

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.

Yesterday, the yield curve – as measured by the difference between the 10 year Treasury and 2 year Treasury yields – inverted, suggesting that the Fed is going to raise interest rates as growth and/or inflation surprise on the low side of expectations…which will be a mistake. https://t.co/5QNZeDWTn4
— Cathie Wood (@CathieDWood) April 2, 2022

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: TradingView.com)

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

Posted: October 6, 2022 | Author: Dr. Duru | Filed under: commodities, Economy, iron ore, Monetary Policy, oil, Salaries | Tags: BHP, BHP Group, Fed Fund Futures, Federal Reserve, Mary Daly, Monetary Policy, real wages, UGA, United States Gasoline Fund | 4 Comments

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

The Fed’s Hawkish Pressure Is Working Against Inflation

Posted: July 3, 2022 | Author: Dr. Duru | Filed under: Agriculture, Bond market, commodities, iron ore, Materials, Monetary Policy, Steel | Tags: 30-year fixed rate mortgage, BHP, BHP Group Limited, corn, FCX, Federal Reserve, Freeport McMoRan, lumber, RIO, Rio Tinto, TIPS, Treasury Inflation-Protected Securities, XME | 5 Comments

The Federal Reserve has stuck by its aggressively hawkish stance despite massive pains suffered in financial markets and growing risks of a recession. Markets are so convinced by and so scared of the Fed that they have raced far ahead of current policy to anticipate a lot of price hikes ahead. Soaring mortgage rates are one example of the Fed’s sharp impact. The 30-year fixed rate mortgage was last this high during the recession of the Great Financial Crisis (GFC).

***Source: Freddie Mac, 30-Year Fixed Rate Mortgage Average in the United States [MORTGAGE30US], retrieved from FRED, Federal Reserve Bank of St. Louis; June 28, 2022.***

These suffocating mortgage rates are an important sign of victory for a Fed whose primary inflation concerns come from housing.

An even clearer sign of victory comes from the bond market, specifically the breakeven rates on five- and 10-year Treasury Inflation-Protected Securities (TIPS). Reuters reported that these TIPS “slid to 2.636% and 2.362%, respectively, a level last seen in September 2021.” Nancy Davis, managing partner and chief investment officer at Quadratic Capital Management LLC, accordingly observed that “the breakeven market, the difference between TIPS versus regular Treasuries, is dramatically downward sloping. It’s barely above the Fed’s long-term average (inflation) target of 2%.” In other words, the bond market is already anticipating that the Fed’s aggressive push to normalize monetary policy and fight inflation will work.

A broad swath of commodities and commodity-related stocks are suffering under the weight of the Fed’s success. The charts below are just a sample: diversified commodities producer BHP Group Limited (BHP), iron ore producer Rio Tinto (RIO), copper producer Freeport McMoRan (FCX), and the metals and mining ETF (XME) (charts from TradingView.com). Even agricultural commodities like corn and lumber look like they have topped. Perhaps these declines represent the early signals of a recession. If so, those concerns may wait for a post-inflationary day.

BHP printed a double-top in 2022 BELOW the 2021 highs.

RIO topped out in 2022 well below 2021’s highs. It now trades at the November, 2021 low and is at risk of challenging the November, 2020 low.

FCX is close to erasing ALL its 2021 gains.

The SPDR S&P Metals & Mining ETF (XME) quickly reversed its entire 2022 breakout.

Spot corn prices closed below the uptrending 200-day moving average for the first time since January. The topping formation for 2022 looks like the dreaded head and shoulders top (shoulders in March and June, the head in April).

Lumber prices topped out in 2022 well below the 2021 highs.

Be careful out there!

Full disclosure: no positions

Persistently Elevated, Unactionable Inflation

Posted: June 10, 2022 | Author: Dr. Duru | Filed under: CPI | Tags: Bonawyn Eison, CNBC, CPI, Fast Money, Federal Reserve, Lindsey Piegza | 3 Comments

Bonawyn Eison, CNBC Fast Money commentator, used the phrase “persistently elevated, unactionable inflation” to describe the current inflationary cycle. Ahead of the disappointing report on May inflation, Eison pushed back on the “peak inflation” narrative as part of an attempt to “reverse engineer” a reason to buy the stock market. While he framed the desperate gaze over the inflation horizon in stock market terms, his characterization is quite appropriate for today’s overall inflation problem. Inflation has been persistent thanks to a powerful convergence of massive monetary stimulus, equally potent fiscal stimulus, and a host of economic disruptions. In turn, inflation promises to remain elevated for quite some time. Perhaps most importantly, the tools for fighting inflation are small compared to the size and the near intractability of the problem. For the Federal Reserve in particular the path to fighting inflation is fraught with the economic perils of stagflation.

The lure of the “peak inflation” narrative has been strong since the report on March inflation. The appeal is natural because of the sense that over time all economic conditions revert to the mean (or the average). However, the rush to declare the end of today’s problem with inflation has been particularly meaningful because it occurs in the middle of a desperate, global desire to return to some form of the “normalcy” we (think) we enjoyed before the pandemic. To their credit, various Federal Reserve members tried to soft pedal the idea of peak inflation, including the San Francisco President back in late April. They have remained nearly uniform in their stated resolve to focus on fighting inflation. The path from 8.6% to anything close to the Fed’s comfort zone does not start with hoping for a peak in inflation.

That 8.6% is where the headline Consumer Price Index (CPI) hit in May. Inflation hurtled March’s 8.5% for a new high for this inflationary cycle. The “peak inflation” crowd might now think surely inflation cannot go any higher from here. Perhaps this hope works out this time, but it matters little in the face of persistent and elevated inflation. Moreover, on the same Fast Money episode featuring Eison’s commentary, Lindsey Piegza, chief economist at Stifel, made an excellent point about the lagging nature of the CPI. Piegza pointed out that the worst impacts of the Russian invasion of Ukraine and the COVID lockdowns in China have yet to hit the CPI. If so, CPI may not continue to increase, but inflation will remain high for quite some time.

"CPI number won't move the needle for the Fed" @Stifel's chief economist @LindseyPiegza is projecting an increase of 8.2% for May. She also says its premature that the market is calling peak inflation. pic.twitter.com/2PCZ6pDucR
— CNBC's Fast Money (@CNBCFastMoney) June 9, 2022

The broad-based nature of the May CPI increases suggests that inflation will indeed remain far above the Fed’s comfort zone for quite some time. Both the month-over-month and, of course, year-over-year inflation numbers were elevated across major categories (numbers are monthly and then year-over-year):

Food: 1.0% and 8.6%
Energy: 3.9% and 34.6%
All items less food and energy: 0.6% and 6.0%
New vehicles: 1.0% and 12.6%
Used cars: 1.8% and 16.0%
Shelter: 0.6% and 5.5%

The persistent rise in shelter costs is particularly notable given the Fed’s sudden sense of urgency on normalizing monetary policy implicitly came from housing costs.

I see at least one lesson from these numbers: inflation will not peak until it peaks. In other words, there is little point in straining the eyes over the horizon seeking the end of this inflationary cycle. Whatever the specific numbers, inflation here in the U.S. and across many nations promises to be persistent and elevated and will frustrate the economic agent who try to act against it without causing other economic fallout.

Be careful out there!

Jim Bianco: “Arguably One of the Worst Forecasts In Fed History”

Posted: April 8, 2022 | Author: Dr. Duru | Filed under: Bond market, Monetary Policy | Tags: Federal Reserve, iShares 20+ Year Treasury Bond ETF, Jim Bianco, Monetary Policy, TLT | Leave a comment

I thought *I* was critical of the Fed waiting so long to start normalizing monetary policy! Jim Bianco, President of Bianco Research, LLC, took criticism of the now moribund “transitory inflation” narrative to a new extreme. In an interview with CNBC’s Fast Money, Bianco took the Fed to task for what he called “arguably one of the worst forecasts in Federal Reserve history.” As a result, the Fed finds itself stuck with an inappropriately loose monetary in the middle of a high price, supply-constrained economy. The Fed intends to dampen demand through higher borrowing costs and lower stock prices (the wealth effect). The historic gap between job openings and the number of unemployed gives the Fed plenty of room to hike rates (until something breaks).

“The call last year that inflation would be well-contained and transitory is arguably one of the worst forecasts in Federal Reserve history.”@biancoresearch president Jim Bianco digs into why Fed policy is creating carnage for bonds. pic.twitter.com/d5HKpfqaWW
— CNBC's Fast Money (@CNBCFastMoney) April 7, 2022

Fast Money invited Bianco after noticing an extended twitter thread that also took the stock market to task for ignoring rate hike risks. Bianco noted the dichotomy between a bond market that understands the Fed is more focused on controlling prices than growth, and a stock market that keeps doing its best to ignore the prospects. Bianco’s charts show that “the carnage is epic” in the bond market: “This is not only the worst bond market in our career (total return) but might be the worst of our lifetime.” Meanwhile, Bianco insists that what is ahead will hurt all financial assets.

1/11

The story of this hiking cycle continues to be the utter disbelief that the Fed will get very aggressive, and even risk a recession.

Yes, they will!

And their policy is creating carnage in the bond market and eventually losses in your portfolio.

A 🧵to explain
— Jim Bianco biancoresearch.eth (@biancoresearch) April 7, 2022

The Trade

In “The Market Breadth“, I specialize in market opportunities at the extremes of behavior. So hearing that the bond market is suffering historic losses actually intrigues me. I suspect that sometime in the middle of an aggressive tightening cycle, bonds will present a generational buying opportunity. I am not a student of bond markets, so I will have to rely on the technical signals from a proxy bond instrument like the iShares 20+ Year Treasury Bond ETF (TLT). The weekly chart below suggests that the opportunity zone on TLT sits somewhere between the 2013 lows (government shutdown drama) and the lows of the financial crisis. I assume the lows of 2018 will be an insufficient stopping point, but I will watch closely for a bounce at that level. On the way down, I have been fading TLT rallies with put options.

***The iShares 20+ Year Treasury Bond ETF (TLT) is in a bear market with a 26% drawdown from its all-time high during the stock market crash of March, 2020.***

Be careful out there!

Full disclosure: no positions

The Federal Reserve Fears On-Going Inflationary Pressures from Rents

Posted: April 3, 2022 | Author: Dr. Duru | Filed under: Central bank, Housing, Monetary Policy | Tags: Federal Reserve, Federal Reserve Bank of St. Louis, housing prices, Monetary Policy, PCE, rent, services | Leave a comment

I recently complained about the Fed’s belated sense of urgency in trying to get inflation under control. The Federal Reserve Bank of St. Louis shed some light on the specific points of concern for the Federal Reserve. In an economic article titled “Breaking Down the Contributors to High Inflation“, the St. Louis Fed described a 12-month lag for housing price dynamics to feed into rents. Given the soaring prices of housing for over a year, rents are due to soar from already high levels for at least the next year or so. Here is the instructive chart:

The Fed’s core concern comes from the out-sized influence of housing services on the PCE (Personal Consumption Expenditures): “Given that housing services constitutes the largest subcomponent of PCE, accounting for roughly 18% of total consumption expenditures, the impact of housing services inflation on overall PCE inflation is always significant.” In other words, I interpret the Fed’s recent religion on normalizing interest policy as a belated attempt to cool down price appreciation in the housing market.

The St. Louis Fed also put this concern in context by comparing today’s inflation with the inflation from the last economic expansion from July 2010 to January 2020. Interestingly each of the three components of the PCE – durable goods, non-durable goods, and services – have contributed around the same amount of extra inflationary pressure in absolute terms, ranging from 1.46 to 1.71 percentage points. However, with a 65% of total consumption expenditures, the promise of on-going upward pressure on services inflation promises to drive the overall PCE ever higher. The Fed finally could no longer sit still on rates.

(For a good read on belated inflation concerns, review Jason Furman’s critique of the economics profession: “Why Did Almost Nobody See Inflation Coming?“)

Be careful out there!

Full disclosure: no positions

Transitory Complete: Fed Chair Jay Powell Gets Comfortable With the Inflation Hawks

Posted: March 22, 2022 | Author: Dr. Duru | Filed under: Automobiles, Economy, Government, Monetary Policy | Tags: Federal Reserve, Jerome Powell, new car prices, recession, used car prices | 7 Comments

Transitory Complete

Pandemic-era inflation pressures were not transitory after all. The inflation watchers I follow never believed the narrative given the Fed’s insistence on maintaining historically accommodative policy well past its expiration date. Indeed, the transitory in the economy turned out to be the deflationary psychology of Federal Reserve Chair Jerome Powell.

The journey has been quite a ride for Fed-speak. In July 2020, Powell reassured an economy in lockdown shock that the Fed is “not thinking about thinking about raising rates.” When murmurs and then gripes about creeping inflation emerged in early 2021, Powell insisted inflation pressures would be transitory. In late April of that year, Powell explained the theory at that time behind transitory inflation. Transitory stretched out longer and longer and longer, until finally in December, 2021 testimony Powell essentially asked everyone to leave him alone about the unfortunate and untimely phrase. Now, with inflationary pressures worsening, Powell has found inflationista fervor. Powell even declared that the Fed is ready to take rates higher than the neutral rate. The mad scramble has begun; the Fed wants to get a raging fire under control.

A Pivotal Speech

Today, March 21, 2022, Powell gave what I think is the pivotal speech of his career as Fed chair. With the appropriately ominous title “Restoring Price Stability“, Powell started with this proclamation to the 38th Annual Economic Policy Conference National Association for Business Economics assembled in Washington, D.C. (emphasis mine):

“…the current picture is plain to see: The labor market is very strong, and inflation is much too high. My colleagues and I are acutely aware that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials like food, housing, and transportation. There is an obvious need to move expeditiously to return the stance of monetary policy to a more neutral level, and then to move to more restrictive levels if that is what is required to restore price stability. We are committed to restoring price stability while preserving a strong labor market.”

For the folks who might still be in transitory thinking, Powell went on to clarify “…the inflation outlook had deteriorated significantly this year even before Russia’s invasion of Ukraine.”

In racing against the wildfire, Powell and the Fed have an ambitious goal. They want to avoid a recession by tapping the brakes on excessive demand in the economy just enough to gently match limited supply. The strong labor market is both a blessing and a curse in this effort. Powell did not use the term “wage-price spiral” inflation spiral”, but he essentially described such a potential dynamic for today’s economy. Companies are struggling to hire. Employees are shifting into new jobs to gain higher wages.

“There are far more job openings going unfilled today than before the pandemic, despite today’s unemployment rate being higher. Indeed, there are a record 1.7 posted job openings for each person who is looking for work. Record numbers of people are quitting jobs each month, typically to take another job with higher pay. And nominal wages are rising at the fastest pace in decades, with the gains strongest for those at the lower end of the wage distribution and among production and nonsupervisory workers”

Powell summarized: “Overall, the labor market is strong but showing a clear imbalance of supply and demand.” Thus, the Fed feels compelled to “moderate demand growth.” In the process the Fed hopes that the labor market’s very strength will withstand a period of aggressive monetary tightening.

Powell explained that the big surprise came from the stubborn persistence of “supply-side frictions.” The economy cannot handle the rapacious demand in today’s economy without sending prices ever higher. In turn, spiraling inflation threatens to erode wage gains especially for lower-income workers.

No Time to Wait Anymore

Interestingly, Powell provided automobile prices as a good example of the inflation problem. There was a time when commentators insisted soaring car prices would be transitory. Auto prices are now transitory complete. Powell lamented “production remains below pre-pandemic levels, and an expected sharp decline in prices has been repeatedly postponed.” Prices for new cars soared almost all of last year and suddenly look ready to take off again. Used car prices soared even more and could lift again if new car prices rev up again. Regardless, no “base effects” here as worker’s wage gains look sure to come under more pressure.

Source: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: New Vehicles in U.S. City Average [CUSR0000SETA01], retrieved from FRED, Federal Reserve Bank of St. Louis, March 21, 2022.

Source: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: Used Cars and Trucks in U.S. City Average [CUSR0000SETA02], retrieved from FRED, Federal Reserve Bank of St. Louis, March 21, 2022.

These mounting pressures have forced the Fed’s hand. The Fed senses it has no time to wait anymore. The Fed is no longer content to wait for the conventional expectations of normalization to bear fruit. In an inflation emergency the Fed needs to act now… (emphasis mine).

“It continues to seem likely that hoped-for supply-side healing will come over time as the world ultimately settles into some new normal, but the timing and scope of that relief are highly uncertain. In the meantime, as we set policy, we will be looking to actual progress on these issues and not assuming significant near-term supply-side relief.”

Inflation is so strong now that Powell has to look out 3 years to envision inflation returning to the Fed’s target of 2%: “I believe that these policy actions and those to come will help bring inflation down near 2 percent over the next 3 years.”

Recession? What Recession?

No Federal Reserve has ever predicted a recession. The central agent trying to command the economy has a vested interest in projecting utmost confidence in its navigation abilities. Accordingly, Powell looked to history as proof that the Fed can pull off the spectacle of the soft landing for the economy:

“I believe that the historical record provides some grounds for optimism: Soft, or at least soft-ish, landings have been relatively common in U.S. monetary history. In three episodes—in 1965, 1984, and 1994—the Fed raised the federal funds rate significantly in response to perceived overheating without precipitating a recession…In other cases, recessions chronologically followed the conclusion of a tightening cycle, but the recessions were not apparently due to excessive tightening of monetary policy. For example, the tightening from 2015 to 2019 was followed by the pandemic-induced recession.”

The Fed is also encouraged by an economy “well positioned to handle tighter monetary policy.”

Powell formerly insisted the Fed would hold rates lower for longer in order to achieve an exceptionally low unemployment rate. The current path flips to the opposite direction. The Fed is willing to go right past the point of neutral rates to get the fire under control: “if we determine that we need to tighten beyond common measures of neutral and into a more restrictive stance, we will do that as well.”

Transitory complete. Bring on the inflation hawks.

Be careful out there!

The Fed Asks “What Inflation?”

Posted: June 23, 2014 | Author: Dr. Duru | Filed under: Economy, Government, Monetary Policy | Tags: CPI, Federal Reserve, Monetary Policy, PCE | Leave a comment

Last week, headlines and pundits were hot and bothered about the potential for the Federal Reserve to fall behind the curve on inflation. While my on-going assumption is that the Fed will indeed chose much higher inflation rather than risk ending the economic recovery with higher rates, I think the current hand-wringing by some is premature. In fact, it seems more the result of either boredom with the Fed’s business as usual policy stance and/or the anxiety on the part of some stock market bears looking for any kind of catalyst to shake the market out of its low volatility slumber.

I was so surprised at all the hand-wringing over a “business as usual” policy statement that I rolled the tape on the press conference. I was wondering what I missed, I actually listened to the conference call a second time (yes, it was painful). The experience made me even more convinced the market over-reacted just as much as it did when Yellen carelessly suggested rates might increase earlier than the late 2015 market projection.

Recent inflation numbers apparently increased expectations that the Fed might show a more hawkish tone. This is reflected best in the first question of the press conference from Steve Liesman of CNBC:

“Is every reason to expect, Madam Chair, that the PCE inflation rate, which is followed by the Fed, looks likely to exceed your 2016 consensus forecast next week? Does this suggest that the Federal Reserve is behind the curve on inflation? And what tolerance is there for higher inflation at the Federal Reserve? And if it’s above the 2 percent target, then how is that not kind of blowing through a target the same way you blew through the six and a half percent unemployment target in that they become these soft targets?”

This was a leading question, especially considering that Yellen made it very plain in her introduction that the inflation readings remain benign. Moreover, long-term expectations for inflation remain tame (also see the Fed’s latest projections). Most importantly, the year-over-year change in the PCE, the Personal Consumption Expenditure, reached the 2.0% target in early 2012 only to quickly plunge from there. Not only might it be premature to project a 2% reading for next week’s release, but there is nothing to suggest that this time is different. The Federal Reserve has the least control over the non-core prices of food and energy, so the escalation of violence and turmoil in Iraq is definitely not the kind of event that the Fed would try to offset with monetary policy.

The Fed still can’t tease the market into sustaining pre-recession inflation levels…
Source: St. Louis Federal Reserve

Perhap’s Yellen’s poor response ignited the flames of disappointment. Yellen did not address PCE directly and instead talked about the noise in the Consumer Price Index (CPI) while reiterating the Fed’s standard guidance on inflation:

“So, I think recent readings on, for example, the CPI index have been a bit on the high side, but I think it’s–the data that we’re seeing is noisy. I think it’s important to remember that broadly speaking, inflation is evolving in line with the committee’s expectations. The committee it has expected a gradual return in inflation toward its 2 percent objective. And I think the recent evidence we have seen, abstracting from the noise, suggests that we are moving back gradually over time toward our 2 percent objective and I see things roughly in line with where we expected inflation to be.”

Ironically, Yellen could have just pointed to the longer-term trend in the CPI. This view dominates any shorter-term noise….

The overall trend on CPI continues to point downward
Source: St. Louis Federal Reserve

The most bizarre part of the buzz on the Fed’s supposed willingness to ignore inflation is that Yellen re-affirmed, re-emphasized that the Fed is all about meeting its price target. It will not tolerate deviations in EITHER direction for long:

“…we would not willingly see a prolonged period in which inflation persistently runs below our objective or above our objective and that remains true. So that hasn’t changed at all in terms of the committee’s tolerance for permanent deviations from our objective.”

This was Yellen’s response to Liesman asking about the Fed’s tolerance for higher-than-target inflation.

I feel irony in my skepticism about a Fed ignoring a budding inflation threat: this is the core scenario that has kept me long-term in the gold (GLD) and silver (SLV) trades. My thesis/assumption back in 2009/2010 was that the Federal Reserve would be extremely reluctant to tighten policy even as the economy strengthened out of fear that rate hikes would quickly kill the economy. By the time the Fed was ready to hike rates, the “inflation genie” would already be out the bottle. Granted, I am not nearly as rabid about this view, especially since I have come to appreciate the deep entrenchment of the lingering post-recession deflationist psychology in the economy.

So, overall, I am very skeptical that this episode is the long-awaited lift-off of inflation and a lagging Fed. I actually think the Fed is right to look through the current “warming” in inflation readings, and I think it will find vindication just as the Bank of England did during a similar episode under former Governor Mervyn King. When the Fed asks “what inflation”, I find myself surprisingly agreeing for now…

To me, the data do not support the notion that broad-based inflation is taking hold in the economy. We do not even have wage pressures, not to mention all the slack that remains in the economy as evidenced in part by extremely low levels of housing production. Just do a web search or read mainstream financial magazines to see anecdotally how many people are still worried about the sustainability of the so far very weak housing recovery. I find it hard to believe we will get strong inflation with all this weakness and deflationary fears. On the commodity side, copper and iron ore have experienced major price declines in recent months that also fly in the face of any kind of sustained inflationary pressure in the economy.

Full disclosure: long GLD, SLV.

Inflation May Be Dead, But Inflation Watch Is Not

Posted: June 15, 2013 | Author: Dr. Duru | Filed under: Australia, commodities, Monetary Policy | Tags: Federal Reserve, inflation rate, Reserve Bank of Australia | 2 Comments

Things have been pretty quiet around here. Every now and then I see a story about rising prices somewhere in the world and think the story would make a great quick post for Inflation Watch. However, I usually do not feel the same sense of urgency I had from 2008 through about 2011 when I felt that rapid inflation was the imminent result of extremely accomodative monetary policy. Everywhere I look, commodities continue to decline in price. Most commodities reached a peak in 2011 and that peak of course had me convinced more than ever that inflation was soon to be a big problem.

Now, thanks to a friend, I am ever closer to accepting that inflation may not be a problem for an even longer time than I expected. He sent me a link to an article called “The Fed won’t taper as long as inflation is low” (by Rex Nutting at MarketWatch) that makes the convincing case that not only is inflation low, but the Federal Reserve has so far seemed powerless to generate the inflation it wants. (I recognize the limitations of government data on inflation, but I do not subscribe to theories that they are concocted specifically to hide true inflation). Incredibly, core inflation is apparently at its lowest point since 1959 (the core PCE price index):

Rex Nutting uses this graph to make the point that all the Fed’s QE have failed to go reflate according to the Fed’s goals

Nutting also links to a paper from the Federal Reserve Bank of New York called “Drilling Down into Core Inflation: Goods versus Services.” In this paper, authors M. Henry Linder, Richard Peach, and Robert Rich demonstrate that more accurate inflation forecasts come from breaking out CPI into a services and a goods component. Nutting uses this as reference for the claim that the Fed is failing because of global disinflation. This global disinflation is responsible for a decline in the prices of the goods component. Services inflation is much more sensitive to domestic forces (we all know about skyrocketing healthcare and education costs). However, I am not sure where housing sits on this spectrum. It seems to provide a crossroad of forces given housing is not tradeable but foreigners are certainly free to overwhelm a housing market with cash. Foreign demand is reportedly helping to drive up housing prices in some of America’s hottest housing markets like in California and some parts of Florida.

All this to say that, for the moment, inflation is all but dead. But “Inflation Watch”, this blog, is NOT dead. I remain vigilant because I believe that when inflation DOES come, the Federal Reserve will either be ill-equipped to handle it and/or unwilling to snip it early for fear of causing a severe economic calamity. I am a gold investor, and I am eager for another chance to invest in the midst of a commodity crash (I am LONG overdue for an update to my framework for investing in commodity crashes/sell-offs).

The chart below from the Reserve Bank of Australia (RBA) shows that commodity prices remain at historically high levels, mostly thanks to rapacious demand from China. The current relative decline is what is helping to drive goods inflation down. The 2011 peak was well above the pre-crisis peak where prices have fallen now. Also note that prices are much more volatile. I suggest that this chart should remind us that commodity prices are a tinder box that can flare up at anytime. Aggressive rate-cutting by the RBA should also help keep prices aloft.

From the Australian perspective, commodity prices remain historically high although they have returned to their pre-crisis peak.

So stay tuned. Just when everyone finally concludes that the world has reached a golden age of disinflation where surpluses abound across the planet…that could be the exact moment the tide turns.

Be careful out there!

Full disclosure: long GLD

The Federal Reserve finally tries to fight a bubble…in the price of farmland

Posted: October 18, 2011 | Author: Dr. Duru | Filed under: Agriculture, Banks, Government | Tags: farmland, Federal Reserve, regulation | Leave a comment

(Hat tip to a friend who pointed me to this article)

Under Alan Greenspan, the Federal Reserve was known to stand on the sidelines while bubbles in asset prices grew and grew. Greenspan had a lot more faith in the Federal Reserve’s ability to mop up the subsequent mess caused by a bubble’s collapse than in its ability to stop a bubble, much less identify one.

It seems times have changed. On October 13, Businessweek chronicled the Fed’s efforts to make sure that soaring prices in agricultural land do not lead to another messy bubble and economic calamity. Prices have indeed soared across the midwestern United States:

“The Kansas City Fed reported land values were 20 percent higher than a year ago. The Chicago Fed reported a 17 percent increase in its district, the fastest increase since the 1970s. Nonirrigated farmland in the Minneapolis Fed district increased 22 percent in price.”

The factors driving these increases are the same as I reported from a related Planet Money piece: “Land prices have doubled in Iowa over the past few years“: “elevated crop prices, soaring farm income, and record-low interest rates.”

As a result, nervous regulators are demanding rigorous stress tests of banks up to their gills in agricultural loans. Businessweek also reports that regulators are “…scrutinizing the lending standards, loan documentation, and risk management at the country’s 2,144 agriculture banks.”

I will be very interested in the outcome of all this scrutiny. The same Federal Reserve that helped create record low interest rates is working to ameliorate the impact of those very same interest rates. This episode is a reminder that flooding an economy with liquidity does not produce equal outcomes for all sectors. Recovery and prosperity does not even need to appear in the sectors most impacted by the malaise the Federal Reserve scrambles to repair. Instead, the money tends to collect where it will generate the highest returns due to other economic factors. Currently, it seems that the bet is on farming. I believe the Federal Reserve was aiming for housing…

Watching for inflation here, there and everywhere (also see us at twitter.com/InflationWatch)

Don’t Come Crying to the Fed Anytime Soon

Fresh Wind for the U.S. Dollar

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The Conundrum

The Fed Stays On Message

The Trade

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The Fed Gives Us What We Want

What We Want Is Not Free

A Golden Epilogue

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Kashkari’s Confessional

Easing Financial Conditions

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The Claim

Chasing the Trend In Inflation

Where Is the Policy Implication?

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Appendix: Notes from the Q&A session

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A Letter or A Plea?

A Deflation Is Already Here

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

Clinging to the ARK

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The Trade

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Transitory Complete

A Pivotal Speech

No Time to Wait Anymore

Recession? What Recession?

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