Chas Craig, BridgeTower Media Newswires
A June 2020 column stated that it seemed reasonable to consider the prospects for meaningfully higher inflation than the Fed’s 2% target. Arguing that government deficits can’t be continuously monetized without eventually causing an inflationary impulse. At the time of that writing the difference in yield between 30-year nominal and inflation protected Treasury bonds (the breakeven rate), a rough estimate of the market’s expectation for average inflation over the period, was 1.5%, a level well below the Fed’s 2% target.
By April 2021 the 30-year breakeven had risen to 2.3%. I took the reversal in market sentiment as an opportunity to make the counterpoint to my earlier argument. The crux of it – we clearly have deflationary undercurrents in our economy. If this were not so, the Fed would not have spent the post-GFC-pre-Covid period undershooting their inflation target despite mostly loose monetary policy, large fiscal deficits and, at least by the end of 2019, a tight labor market. The three themes highlighted (1) an aging population, (2) automation and technology adoption and (3) globalization.
The tug of war between those two arguments informs long-term inflation expectations. One might call these the non-transitory factors. Globalization seems the biggest wild card of these, and recent world events add credibility to the case for this to flip to being additive to inflation.
Actual and expected (30-year breakeven rate is now 2.5%) inflation have continued to rise. Inflationary conditions became of greater concern last fall when inflation broadened from specific Covid-related supply chain-stricken areas, most notoriously used cars. This phenomenon is well-captured by the Trimmed Mean PCE Inflation Rate: https://fred.stlouisfed.org/series/PCETRIM12M159SFRBDAL. This inflation measure disregards outliers (e.g., used cars) to provide a gauge of normalized inflation. In looking at the graph for the post-Covid period, one sees that this inflation measure stayed below 2% until August 2021 but has aggressively moved higher since, most recently registering 3.6% (2/22).
In response, the Fed is poised to aggressively raise interest rates and reduce the size of its bond holdings. A common refrain on Wall Street is that “The Fed knows how to fix inflation.” Fair enough, and the Fed has many tools at its disposal to tighten monetary policy given that the starting point was the most accommodative in history. The problem (for optimists) with that argument is that it invokes the early-1980s when Fed Chair Volker caused a recession to tame inflation.
A more optimistic point of view – Like how the Great Depression Era gave future Feds a “don’t do that” playbook for addressing a financial panic, the 1970s period provides an analogous lesson for not letting inflation become entrenched. Essentially, the 1970s saw a series of failed half-measures, which later required a Volker-administered double-measure.
My point, there is reason to be optimistic that today’s Fed can administer a full-measure of monetary tightening that achieves the “soft landing” of returning reported inflation figures to the low-single-digits from the high-single-digits without tipping the economy into recession. The most acute supply chain issues will eventually abate, and consumption will revert towards services from goods somewhat. The current tightening cycle also comes at a time of low unemployment and strong private sector balance sheets.
While things like inverting yield curves (While not fait accompli, short-term Treasury yields exceeding long-term Treasury yields, an inversion, is a formidable warning signal of an impending recession.) must be respected, I consider myself “cautiously optimistic” that a soft landing can be achieved. Importantly, such a soft landing is imperative for the equity market, as an S&P forward P/E multiple of 19.5x (per 4/1/22 FactSet report) leaves little room for error.
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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).
