For Rate Watchers, This Day Is of ... Interest

In the world of interest rates, Wednesday was a bit jolting. In the morning we got the U.S. consumer price index figure, which surprised to the upside. This index continues to show more breadth, which to me suggests that inflation is becoming something other than transitory. Then, in the afternoon the Federal Reserve released the minutes of its September meeting. Readers may remember this meeting caused the market to reprice its expectations for rate hikes, so learning anything more we can about the Fed's thinking is crucial. Here's my analysis on both. CPI Accelerates, Broadens In Fed Chair Jerome Powell's Jackson Hole Speech, he made a number of points arguing that inflation may decelerate on its own. One of them was that, The spike in inflation is so far largely the product of a relatively narrow group of goods and services that have been directly affected by the pandemic and the reopening of the economy. This argument is getting harder and harder to make, and this CPI report isn't helping him. Inflation is becoming broader even as those spike item prices subside. We can look at this a few different ways, but they all give the same result. The Cleveland Fed produces a Median CPI which just takes the median price change of all items in the CPI. My taking the median, you ignore any spikes up or down as well as weights. If we look at this series on a 6-mo annualized basis, it is up 3.7%. I've also been tracking a weighted average of the most pandemic-impacted items, including airline tickets, hotels, new and used cars, rental cars, and apparel. Just as Powell suggested, these prices have started falling, with the average of the group down 1.4% this month after falling 1.5% last month. But here again, as these prices are falling, other prices are accelerating. The Core CPI measure excluding this pandemic-spike set has advanced 7.8% on an annualized basis over the last six months. Lastly we should mention the Fed's favored inflation measure, which is core personal consumption expenditures. This has not yet been updated for September, but we should note that this series too has shown inflation broadening. The Dallas Fed calculates a Trimmed Mean PCE, which takes out the 16% highest and lowest price changes, so Powell's spike items should be removed. That series has risen by 2.6% over the last six months, well outside of the Fed's comfort zone. Below, I've plotted all three of these series so far this year (all on a six-month annualized basis) and as you can see, there's been meaningful acceleration everywhere. / Source: Bureau of Labor Statistics, Federal Reserve Bank of Cleveland, Federal Reserve Bank of Dallas Taper in November or December? There wasn't much in the Fed meeting minutes that we didn't already know. It was somewhat interesting that the quantitative easing tapering discussion was fairly detailed, including a pretty specific plan laid out for how to proceed. That suggests the consensus to start tapering was more or less already made, and thus they had time to hash out the details. I will only highlight one mini-debate within the minutes. There was a lengthy discussion about what the long-term outlook for employment participation would be. On one side, the pessimists: Various participants suggested that a complete return to pre-pandemic conditions was unlikely, as the pandemic had prompted reductions in the workforce that were likely to persist, including a large number of retirements and other departures from the labor force. And then, the optimists: A number of others, however, assessed that once the COVID-related concerns that were currently weighing on labor force participation passed, the participation rate and the EPOP ratio could return to, or even exceed, the pre-pandemic levels. Which of those two views turns out to be more correct is extremely important. If it is the former, that would indicate the economy is near its capacity now and it will soon slow significantly. While that might suggest a bit more inflation in the short-term, it also means that the economy can't handle much monetary tightening and interest rates will stay relatively low. However if it is the more optimistic view above, the expansion can continue for quite a while, and the Fed could hike slowly over a much longer time period. That ultimately would mean interest rates end up much higher. Curve Flattening = Fed Mistake? The yield curve has flattened the last few days as the market has begun to price in more rate hikes. This chart shows the implied future Fed target rate based on the euro-dollar futures market: Source: Bloomberg As I've written the last two weeks, the curve has always flattened during rate-hiking cycles. Hence it is no surprise that as hikes get pulled forward, the curve should flatten. On Tuesday and Wednesday, however, we got a special version of curve flattening, which bond geeks call a twist. This is where longer-term yields fall, while short-term yields rise. Classically this is the market saying that the Fed is making a mistake: That near-term rate hikes will cause growth to tank. This is a view that remains commonly held among bond traders. Personally, I think this is a huge leap in logic. First, it's pretty harsh to declare the Fed has already screwed up when it hasn't even done anything. Second, as you can see in the chart above, the market has priced in Fed funds ending about 1.5% three years out, which is below where it was when the pandemic started. If you think hiking to 1.5% over three years will cause growth to tank, you are suggesting the economy will be weaker in 2024 than it was in 2019. While I suppose that could happen, seems like a huge assumption about such a far off date. Third, this mistake reasoning suggests the Fed is on some inexorable path to several rate hikes. Why would that be? If the economy slows after a few hikes, the Fed will stop. I'd give the Fed some credit for being able to pivot their plans if necessary. You don't need to go far back in time to see this in action: The Fed did exactly this pivot in 2018-2019. There was some market choppiness, but the real economy performed just fine, and ultimately financial markets did, too. My view is that inflation will only remain high if aggregate demand is also strong. If that's true, Fed hikes will only be happening amid economic strength. If the economy slows, inflation will also subside, and rate hikes will halt, or never start in the first place. I tend to think the economy will emerge from the pandemic stronger than it was in 2019, which implies there is a good amount of room for policy to tighten.

For Rate Watchers, This Day Is of ... Interest

The consumer price index surprises to the upside and the Fed meeting minutes are out. Here's my take on both.

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