What Is the Price of Panic for the Fed?

No matter what excuses you have for rising prices, inflation is running way too high for the Federal Reserve's comfort, and its time to act is drawing closer with each inflation read. Indeed, Wednesday's Consumer Price Index report showed that inflation remains red hot in the U.S., with overall consumer prices rising for calendar 2021 an eye-popping 7% -- 5.5%, when you exclude food and energy. Here's my take on this CPI report specifically, what we can expect in the coming months, and how the Fed will respond. Supply chains vs. robust demand Inflation is fundamentally about too many dollars (demand) chasing too few goods (supply). Which of those two factors is driving inflation can be hard to untangle. For example, we know there are challenges getting imported goods from our ports to retailers and households, which seems like an obvious supply-side issue. On the other hand, we wouldn't have that problem if not for the fact that consumers are buying far more goods than they pre-Covid. In this CPI report, most of the larger price increases came in goods, suggesting that supply constraints are still at play. Household furnishings, apparel and autos all rose by at least 1% this month alone. There has been plenty of chatter that the auto manufacturers are getting back to full production capacity. In addition, it seems that many retailers haven't been raising prices so much as they have been not putting things on sale as much. Once inventories are more normalized in both these sectors, it will probably ease pricing pressures to some degree. Meanwhile, services inflation was much more tame. Excluding energy, the price of services only rose 0.3% for the month. That sounds like good news on the inflation front until you realize that services inflation has advanced at a 4.5% annualized clip over the last three months. I think this leaves us with a good news/bad news situation. The good news is that if Omicron cases are starting to peak, and if manufacturers are getting up to full capacity, some of the supply driven inflation pressure could subside. That may mean that year-on-year inflation is nearing a peak. The bad news is that even if we take out the particularly supply impacted sectors, inflation is still running quite high for everything else. This tell us that inflation is a much more generalized problem than can be dismissed on supply-chain woes alone. Panic time at the Federal Reserve? The Fed is in a tricky spot. The Fed has to take some action: No matter how you slice it, 7% CPI is an unacceptable inflation rate. But the Fed remains deathly afraid of hiking too much and causing inflation to fall below 2% again, or worse, wind up in a recession. That's why it's waited so long to start hiking already. The credibility of Average Inflation Targeting (AIT) is on the line, and Chair Jerome Powell does not take that credibility lightly. In addition, the Fed knows that the effect of rate hikes on the economy can't be measured in real-time. Rate hikes today probably don't impact the economy much for at least six months. Given both their fear of too much tightening and this lag effect, the Fed is going to strongly prefer hiking as slowly as they possibly can. That way they can see the signs that policy has tightened too much before it causes much damage. Four hikes in 2022? In the last few days, chatter that the Fed may hike four times has gained steam. This week Goldman Sachs came out with such a forecast, and J.P. Morgan CEO Jamie Dimon said he'd be surprised if the Fed didn't wind up hiking at least five times. While it is certainly possible the Fed hikes four (or even more) times in 2022, the bar may be higher than you think. The Fed will most likely hike in March and then hike again in June or July. In between those two periods they will probably make some announcement about shrinking their balance sheet. They will view that as three actions all in the first half of the year. I think after that they will want to wait a few months. This will be in part to see if inflation subsides on its own at all, and in part to see what effects those three actions have. Hence I think unless inflation really forces their hand, I'm not sure there's enough of a timeline to fit in four hikes this calendar year. Furthermore if indeed headline inflation peaks in the next couple months, that will probably give them enough of an excuse to remain a bit patient. They may also choose to use more aggressive quantitative tightening instead of more rate hikes, as they know this has a relatively small effect on the economy, but still creates the optics of acting to quell inflation. Rates are really about 2023 Whether the Fed hikes three or four times in 2022, the real driver of the bond market will be how many hikes happen in 2023 or beyond. As I said above, the Fed will have some room to stay patient in 2022. That patience may pay off in 2023 if inflation decelerates to near 2%. Or the Fed may be forced to throw patience out the window if inflation remains in the 3%+ area. I don't think the 2023 picture will come into focus until closer to mid-year. Each passing month will give us important clues about the state of consumer spending, income and inflation that will make the post-Covid trend a little more clear. I'd expect this high degree of uncertainty will cause interest rate volatility to ramp up in the coming months. Relief rally in bonds? Coming into this CPI report, the Treasury market was unusually oversold. Given that, I thought it possible that an in-line CPI report would touch off a bit of a relief rally in bonds. Perhaps the oversold condition was caused by aggressive shorts coming into CPI, or buyers wanting to wait until after CPI to commit to positions. It would be a classic set up, where a seemingly benign economic number causes an outsized market reaction due to one-sided positioning. There was a very minor rally after the number, but by late morning it had completely petered out, and bonds were trading roughly unchanged. That's not a great sign for bonds in the short-term. It suggests there aren't any buyers waiting on the sidelines, nor paper-handed shorts looking to cover. That is a changed dynamic from the second half of 2021, and could mean there is room for rates to keep rising in the near-term.

What Is the Price of Panic for the Fed?

The Fed has to take some action: No matter how you slice it, 7% CPI is an unacceptable inflation rate. Here's my take on inflation and what's ahead.

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