The Economy, Inflation, Have Been Burning Up. Are They Burning Out?

Could inflation --- and maybe the economy, too -- be peaking? The Federal Reserve has only hiked interest rates by a quarter of a percentage point off zero, and yet we're seeing nascent signs of slowing. We saw this on Tuesday, when, despite an 8.5% consumer price index increase year-over-year, the bond yields fell and bets on Fed rate hikes in 2023 subsided. Here are my thoughts on a potential turning point, including how to read the signs and what paths the economy could take going forward. Small Signs of Peak Inflation We have been hearing for a couple weeks that trucking freight volumes were declining. Logistics data provider FreightWaves tracks both volumes and cancellations, which can be a sign of how tight capacity is. Both are showing softness in March. Freight can be hyper-cyclical, however, which is to say it can have severe ups and downs, even as the rest of the economy stays steady. But it could also be a sign that companies have built up more inventory than they want, possibly because they overbuilt or overbought leading up to this point. Or, it could be because they see consumption slowing down. This week there were two more data points to support the idea that maybe things are slowing a bit. The first was CarMax's earnings report, where it said that used car sales volume dropped by 6.5% last quarter. Given how large CarMax is, that is a very telling data point about the broad used car market. That could be a sign that a combination of higher prices and higher interest rates are starting to crimp demand for large ticket items. The other data point came from the CPI itself. While the headline year-over-year number was an eye-watering 8.5%, the details gave a more nuanced story. Excluding food and energy, CPI only increased 0.3% in March, which was below consensus. Moreover, looking at goods prices only, overall prices actually fell by 0.4%, and every major category of goods prices decelerated from February. This Could Be Benign... Again, this is certainly not definitive evidence of the economy or inflation or both slowing. Economic activity never moves in a straight line. Ups and downs are expected, even when the economy overall is strong. This could also indicate that consumers are shifting from goods spending to services spending, not curtailing consumption overall. Pre-Covid, services made up about 69% of total spending, whereas now that is just 65%. It could easily be that household spending remains robust, but that this mix reverts to pre-pandemic levels. If that were happening right now, we'd see freight volumes fall (you don't ship services), inventories build (you don't store services), and prices on goods slow down as compared to services. These would look like bad omens, but would really just be a shift in wallet share. In this benign scenario, it isn't obvious that inflation overall would decelerate in a big way. While perhaps some supply chain tightness in goods production and shipping would subside, it may bring on new tightness on the services side. Most obvious would be that services generally are more labor intensive than goods, and labor surely is in short supply. We see the potential for what could happen in the March CPI figure, where goods inflation was down 0.4%, but services inflation was up 0.6%. On net, that would still be 4% overall CPI on an annualized basis. That's slower than where we are now, but still very elevated. ... Or It Could Be ... Of course there is a less benign scenario as well, which is where higher interest rates are already slowing aggregate demand. It may seem odd that such a thing is possible, when the Fed has only hiked by a quarter point. How could that mean that policy is already tight? The answer lies in just how unprecedented this rate-hiking cycle is. There has never been a time in the past when the Fed was this aggressive and also telegraphed its intentions. Because of this transparency, the entirely yield curve has repriced rapidly. Consider that at the end of November, the 2-year Treasury was around a half point. By the time the Fed made its first hike, the 2-year had already jumped by 50 basis points. It rose another 50bps thereafter, without any other Fed action. Compare this to 1994, when then-Fed Chair Alan Greenspan hiked by three percentage points in a 12-month period, including three 50bps hikes and one 75bps hike. That's the closest historic comparison to what's happening now. But if you look at the chart below, you see that the 2-year roughly followed Fed funds higher, it never anticipated much of anything. In the current cycle the 2-year was able to rise by 200bps with only one Fed hike. In 1994, the 2-year didn't rise by 200bps until the Fed had already hiked by 125bps. (source=Bloomberg) In effect, the Fed giving so much forward guidance changes how policy impacts the real economy. Because general interest rates have risen ahead of actual Fed funds, it is effectively like the Fed has already hiked several times. You've probably heard that monetary policy operates with a lag, usually thought of as somewhere between 6-18 months. But certainly that time horizon compresses when the curve has priced in such a large change so quickly. A Little Softening Might Be Good for Stocks, but ... If inflation were to incrementally slow, indicating that Fed policy and guidance are having an effect, that would probably be good news for equities. While it would probably still mean the Fed hikes several times in 2022, it might mean that hikes stop by 2023. If so, that would lower the odds that the Fed hikes well beyond some number the economy can handle, and thus lower the risk of a stagflation scenario. All that should buoy stocks. Unfortunately, it is a narrow path, where the economy is slower but not slow. For inflation to subside, households have to spend less nominal dollars. Households aren't going to spend less while incomes are growing at this pace. Incomes aren't going to slow unless wage growth slows. Wage growth isn't going to slow as long as the labor market is this tight. Hence, it is hard to see how inflation slows without some rise in unemployment. So, if we get a little bit of slowness and that allows for a little bit of interest rate relief, stocks will cheer. But if it is actually a slowdown, the decline in earnings will easily overwhelm any benefit from falling bond yields. We saw this dichotomy on display in stocks on Tuesday. Right after the relatively benign CPI report, stocks rallied strongly, but by the end of the day concerns about a real slowdown left equities in the red. For Bonds, a Balanced Risk Part of why bonds have rallied these last few days is simple exhaustion. The market was far oversold and was liable to bounce, given any kind of favorable news. But if you have been sitting in cash or very short-term bonds, waiting for better yield opportunities, this is probably a good entry point. The market is already expecting the Fed to hike all the way to 2.50% in the next year, so if bond yields are going to keep rising, it will have to be because inflation remains a major problem into 2023. While that certainly could happen, the bet is no where near as one-sided as it was six months ago.

The Economy, Inflation, Have Been Burning Up. Are They Burning Out?

Let's tackle the big question: Is inflation, and possibly the economy, too, reaching a peak? We're seeing some possible signs of slowing -- but they could be other, harmless shifts under the surface. Here's my take.

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