Inflation, the Fed and How to Position Your Portfolio Around the Latest Numbers

I have been writing for months that the Fed was likely to keep hiking until unemployment stopped falling. However, inflation could be a wild card as rate policy evolves in 2019. On Wednesday we got a report on the Consumer Price Index (CPI), probably the most well-known inflation measure. On a headline basis, the CPI slowed to 2.2% from 2.5% year over year. Could this be a sign that inflation is slowing? Here are my thoughts on the CPI report specially, what it means for the Fed, and how to position around it. Slowing Inflation Would Give the Fed Breathing Room... There are three competing forces making the Fed's decision difficult: The very tight labor market, which under traditional monetary policy rules would have the Fed not just hiking, but hiking aggressively. Weakness in financial markets, which could be a leading indicator of the cycle turning. Criticism by President Donald Trump, which makes it tough for the Fed to pause rate hikes without compromising their independence (or the perception thereof). If inflation were to slow, it would make it a lot easier for the Fed to pause rate hikes. Without that they would be seen as either catering to financial markets or bowing to political pressure, either of which are problematic. Whereas if inflation slows meaningfully below their 2% inflation target, a pause should be much less controversial. But the Evidence That Inflation Is Slowing Is Mostly Circumstantial While Wednesday's CPI report showed a 0.3 percentage point slowdown on the headline number, the Core measure, which excludes food and energy, showed no such slowdown. That would suggest that the deceleration is entirely about energy prices and not some broad disinflationary pressure. We saw a similar pattern in the Produce Price Index: a deceleration in the overall figure (to +2.5% from +2.9%) but a slight acceleration in the core figure (to +2.7% from +2.6%). It is true that the Fed's preferred inflation measure, the Core PCE, ticked below 2.0% in the November report, coming in at +1.8% year over year. However, it is a real stretch to draw any conclusion from a single month's oscillation. Beyond energy there are a few spots that could be harbingers of slower inflation. This CPI report showed higher used car prices, but that's probably a one-off. If anything, auto demand seems to be slowing. Home price appreciation also may be slowing, which may put some pressure on rents as well. Lastly, we have the surge in the dollar, which is up 2.5% since September 20. That could certainly be something of a disinflationary force if it keeps up over the next few months. All this is circumstantial evidence at best, however. For example, home prices could be slowing because of higher interest rates, but once they find the right equilibrium there is no obvious reason why they should keep slowing. The other slowing items within the CPI could have similar reasons why they turn out to be one-offs. And the Fed Has Hiked With Inflation at This Level Several Times The Fed is sensitive to changes in inflation rates obviously, but not hyper-sensitive. During this cycle the Fed has hiked five times when Core PCE was +1.8% year over year or lower. This includes a hike in June 2017 when Core PCE had dropped to +1.6% from +1.9%. They did skip hiking rates in September of that year, but by that time the reading on Core PCE was just +1.4%. Then they were back at it in December, hiking again with Core PCE rebounding to +1.6%. This doesn't mean that 1.6% is a magic threshold, but it does say that the Fed was inclined to hike despite a much more obvious consumer price deceleration than we are seeing now. The Fed Will Hike in December, and Probably Again in Q1 Talk of the Fed skipping their rate hike in December is way off base. If the Fed wanted to back off that hike they would have already made overt hints to that effect. Beyond that, while it is possible that additional evidence of a slowing economy could emerge in the first quarter of 2019, the odds definitely favor another rate hike then as well. If the circumstantial evidence I mentioned above turns out to be the early stages of a more meaningful inflation deceleration, I strongly suspect that means the whole economy is slowing. It is unlikely at this stage in the cycle that we'd get a lasting period of slower inflation without a slower overall economy. The Goldilocks era is over. Trades I Like I still like the U.S. dollar, but it is late innings on this trade. I expect a rally into the Fed meeting next week and I'll reassess then. I also still like curve flatteners quite a bit, but I've moved my position in recent weeks from long 20-30 year bonds to long 10-20 year bonds. I'm still short 3-7 year bonds. I've lightened up on credit risk given the fact that the cycle is now very late no matter what. I wouldn't be passively long iShares iBoxx $ High Yield Corporate Bond ETF , SPDR Bloomberg Barclays High Yield Bond ETF or Invesco Senior Loan ETF here at all.

Inflation, the Fed and How to Position Your Portfolio Around the Latest Numbers

The evidence that inflation Is slowing Is mostly circumstantial.

Columnist Conversation

This Weekend on Real Money

This Could Get Messy

Latest AAP Podcast With Helene Meisler!

COLUMNIST TWEETS

Please Join or Log In to manage and receive alerts.