Sources: U.S. Bureau of Economic Analysis, Personal Consumption Expenditures Excluding Food and Energy (Chain-Type Price Index) [PCEPILFE], retrieved from FRED, Federal Reserve Bank of St. Louis. U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items Less Food and Energy in U.S. City Average [CPILFESL], retrieved from FRED, Federal Reserve Bank of St. Louis, November 27, 2024.

October’s core PCE, PCE excluding food and energy, came in at 2.8% in October, up from 2.7% in September. Core PCE was last higher in April at 2.9%. Sticky service inflation is a key driver of the current stabilization. While prices for goods decreased 1.0%, prices for services increased 3.9%. Services expenditures increased across each sub-category: housing and utilities, health care, transportation services, recreation services, food services and accommodations, financial services and insurance, and other services. This broad-based strength is indicative of a strong economy where consumer spending remains robust. This robustness also presents a key challenge for the Fed as it seeks to “recalibrate” monetary policy by cutting rates. Even if the job market needs the relief, the (services) economy clearly does not need the rate cut relief at this juncture.

Interestingly, long-term yields decreased in the wake of the hot PCE news. The iShares 20+ Year Treasury Bond ETF (TLT) increased 0.7% (yields down) to a 1-month high. Given this move is inconsistent with a stabilizing, and perhaps now an increasing inflation rate, I attribute TLT’s move to a continuation of the week’s relief rally. TLT gapped higher in relief after Trump selected hedge fund executive Scott Bessent to head the U.S. Treasury Department. Once the dust settles, I expect TLT to fail at or around resistance from its 50-day moving average (DMA) (the red line below) and head back toward the bottom of the current (presumed) trading range. TLT almost tested the bottom of the range after Trump was elected and then again after October CPI came in hot.

Full disclosure: long TLT put

The post Inflation Stabilization Firms with Robust Services Spending appeared first on Inflation Watch.

“A strategy of repeatedly lowering the fed funds target range toward a more neutral level relies on confidence that the neutral level is materially lower than where rates are now. When I look at the available evidence, though, I see substantial signs that the neutral rate has increased in recent years, and some hints that it could be very close to where the fed funds rate is now…ces. I anticipate the FOMC will most likely need more rate cuts to finish the journey. But it’s difficult to be sure how many cuts may be needed and how soon they may need to happen.” – Navigating in shallow waters: Monetary policy strategy in a better-balanced economy, Dallas Fed President Lorie K. Logan, November 13, 2024

“Shifting from my baseline to alternative scenarios, recent information suggests to me that the risk of inflation ceasing to converge toward 2%, or moving higher, has risen, while the risk of an unwelcome deterioration in the labor market has remained unchanged or possibly fallen.” – Musalem: Remarks on Monetary Policy and the U.S. Economic Outlook, St. Louis Fed President Alberto Musalem, November 13, 2024

“While now is the time to begin dialing back the restrictiveness of monetary policy, it remains to be seen how much further interest rates will decline or where they might eventually settle.” – Longer-term Considerations for Growth and Monetary Policy, Federal Reserve Bank of Kansas City President and Chief Executive Officer Jeff Schmid, November 13, 2024

All three speeches included Fedspeak for caution on the pace of rate cuts while maintaining the flexibility to follow the data. These speeches also came on the same day as the release of the October CPI data. This timely convergence of caution and circumspection is important because core CPI maintained the stabilization trend in place since a low in July (see the green line below). Meanwhile, core PCE, the Fed’s favorite indicator of inflation also looks like it is stabilizing. In other words, it seems the Fed is paying attention to stabilizing inflation patterns.

Sources: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items Less Food and Energy in U.S. City Average [CPILFESL], retrieved from FRED, Federal Reserve Bank of St. Louis, November 13, 2024. U.S. Bureau of Economic Analysis, Personal Consumption Expenditures Excluding Food and Energy (Chain-Type Price Index) [PCEPILFE], retrieved from FRED, Federal Reserve Bank of St. Louis, November 13, 2024.

Shelter costs continue to drive the bulk of inflation. For October, shelter costs constituted 65% of the year-over-year increase in the CPI. Housing costs are in a paradoxical juncture where monetary policy could help maintain elevated housing costs no matter where interest rates go. The National Assocation of Homebuilders (NAHB) laments that high interest rates contribute to contraints on supply thourgh an expensive and difficult financing environment for construction loans. On the other hand, looser monetary policy could reignite a housing demand that strains supply further and drives up prices. For now, a surprise rebound in mortgage rates is tamping down housing demand.

A Friendly Message from Gold?

While inflation is stabilizing, gold may have topped out.

Two months ago I interpreted the strength in gold as indicative of a skepticism about the Fed’s implied victory message on inflation. That trend persisted until last week. The resolution of the U.S. presidential election generated a fresh surge in Bitcoin (BTC/USD) and presumably drained interest in gold. The SPDR Gold Trust (GLD) gapped down and lost 3.0%. I was hopeful that the 50-day moving average (DMA) (the red line below) would hold as support. As a (perma) bull on gold, I added call options to supplement my core GLD position. Today’s 1.0% loss in GLD further confirmed a 50DMA breakdown. This bearish technical signal means that I am unlikely to try new short-term trades for a while.

Source for charts: TradingView.com

The new inverse correlation between gold and Bitcoin indicates a sharp shift in preferences with Bitcoin getting an added advantage from expectations of a pro-crypto regulatory regime starting next year.

The Bond Market Remains Wary

Two months ago I claimed that the bond market acted wary about the Fed’s presumed victory over inflation. Sure enough, long-term yields have steadily risen ever since. The iShares 20+ Year Treasury Bond ETF (TLT), which goes up when long-term interest rates go down, is now trading near the bottom of a presumed horizontal trading range. My strategy to fade TLT has worked all the way down.

After TLT gapped up for some reason on the CPI news, I thought I missed my latest profit opportunity. So when TLT faded back to the previous day’s close, I counted myself fortunate and took profits on my latest round of TLT put options. TLT then went on to lose 1.0% for the day.

The U.S. dollar soars

The U.S. dollar index (DXY) has benefited from one tailwind after another. Now, the presumed tailwind comes from the boost it should get with increased tariffs that also promise to prop up inflationary pressures in the economy. Fewer dollars going overseas to buy goods tips the supply/demand balance in favor of a stronger dollar. Two months ago I decided to bet on continues strength in the British pound versus the U.S. dollar by buying shares of Invesco CurrencyShares® British Pound Sterling Trust (FXB). I took the opportunity to buy when FXB tested its uptrending 50DMA. The currency ETF has continued downward from there with little sign of an imminent rebound.

Conclusion

With the Presidential election behind us, the bets on stabilizing (or even stronger) inflation are clarified for now: long Bitcoin, long gold only after Bitcoin enthusiasm wanes somehow, long U.S. dollar, and short TLT. While I sold all my Bitcoin earlier in the day, I will continue to trade by buying dips. I am conflicted on the U.S. dollar as I stubbornly hold some dollar shorts while trading in and out of dollar longs. At some point, I will commit to a dollar long by shorting EUR/USD. Europe stands to lose in the next administration with a weaker NATO, more contentious relationships, and higher tariffs in a weakening economic backdrop.

The Federal Reserve has ahead as precarious a path as ever while it gets increasingly wary about stabilizing inflation!

Full disclosure: long GLD shares and calls, long PHYS, long FXB

The post The Federal Reserve Is Paying Attention to Stabilizing Core Inflation appeared first on Inflation Watch.

• The Federal Reserve had driven monetary policy to historic heights of accommodation: a 9 trillion dollar balance sheet combined with a return to zero interest rates: an easy money paradigm that itself needed to be transitory.
• The Federal Reserve instituted a risk management framework that targeted tail risks instead of an “expected” path of inflation and its resulting impact on the economy.

Moreover, Stiglitz offered two examples from the economy, autos and shelter, that do not conclusively demonstrate the Fed had no impact on inflation. Even Stiglitz’s discourse on inflation expectations is open to varying interpretations. I will tackle each of these issues one-by-one starting with auto inflation.

Auto Inflation: A Counterfactual

Stiglitz makes a big deal out of the obvious fact that the Fed could not solve chip supply problems in the auto industry by hiking interest rates. While the Fed never staked a claim to such powers, and even acknowledge its lack of such powers, this complaint is common among Fed critics who apparently wanted the Fed to leave monetary policy accommodative and lower for longer. Stiglitz pulls the rug from under the Fed by insisting “Given that its interest-rate hikes did not help resolve the chip shortages, it cannot take any credit for the disinflation in car prices.”

So now with auto prices inevitably lower, critics like Stiglitz are declaring victory on the prediction that car prices would eventually come down. Fine. How about a counterfactual? If the Fed had left rates lower for longer is it credible to believe that the path for prices would have stayed exactly the same (or improve)? I claim the answer is no. Assuming lower loan rates encourage and incentivize more borrowing (indeed this is a fundamental premise for accommodative monetary policy), then rock bottom rates would have fueled on-going and even increasing demand for cars and deepened pressures against short supply. In other words, I am claiming auto inflation would have been even worse and could have caused other cascading problems in the economy.

Even throwing away abstract counterfactual arguments, the actual data is not conclusive enough to suggest the Fed had zero (or even little) impact. The chart below juxtaposes new and used car prices with the auto inventory/sales ratio (cars and light trucks). This ratio puts demand and supply into context. While the the ratio bottomed out in late 2021, it is still nowhere close to pre-pandemic levels. Deflation/disinflation should not be this dramatic with the inventory/sales ratio still at historically low levels. I would have expected a price plunge to accompany a much faster recovery in the inventory/sales ratio. In fact, I would have expected the pendulum to at least swing above 1 again.

Sources: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: Used Cars and Trucks in U.S. City Average [CUSR0000SETA02], retrieved from FRED, Federal Reserve Bank of St. Louis, November 14, 2023. U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: New Vehicles in U.S. City Average [CUUR0000SETA01], retrieved from FRED, Federal Reserve Bank of St. Louis, November 14, 2023. U.S. Bureau of Economic Analysis, Auto Inventory/Sales Ratio [AISRSA], retrieved from FRED, Federal Reserve Bank of St. Louis, November 14, 2023.

In other words, while supply has been slowly normalizing, demand still outstrips supply. This is a condition for higher prices. Yet, resurgent inflation in autos is not likely specifically because high interest rates are constraining and reducing the ability and willingness to pay higher and higher prices. The rate on the 48-month auto loan was last this high in 2002.

Source: Board of Governors of the Federal Reserve System (US), Finance Rate on Consumer Installment Loans at Commercial Banks, New Autos 48 Month Loan [TERMCBAUTO48NS], retrieved from FRED, Federal Reserve Bank of St. Louis, November 14, 2023.

Finally, domestic banks have also tightened lending standards, likely further constraining the ability to pay higher prices. Lending standards tighten with tighter monetary policy as banks become more risk averse and have a higher cost of funds. This is a Fed effect. From the October, 2023 “Senior Loan Officer Opinion Survey on Bank Lending Practices“:

“In a set of special questions, banks were asked to assess the likelihood of approving credit card and auto loan applications by borrower FICO score (or equivalent) in comparison with the beginning of the year. Significant net shares of banks reported that they were less likely to approve both credit card and auto loan applications from borrowers with FICO scores of 620. Moderate and significant net shares of banks reported that they were less likely to approve credit card loan applications and auto loan applications, respectively, from borrowers with FICO scores of 680. In contrast, a modest net share of banks reported being more likely to approve credit card applications from borrowers with FICO scores of 720, while the likelihood of approving auto loan applications to borrowers with FICO scores of 720 was basically unchanged in comparison with the beginning of the year.”

Thus, I claim the Fed deserves at least partial credit for helping to tap the brakes on demand, in the form of ability to pay, in the face of relatively tight inventories. In other words, I find it compelling to create a narrative around a Fed impact that is at least as plausible as the narrative that completely discredits the Fed.

Shelter Inflation

The dynamics of shelter inflation are complex. I grant Stiglitz the point that higher interest rates can exacerbate inflationary pressures by reducing the availability of construction loans needed to increase supply. Interestingly, Stiglitz does not reference the complementary constrain t on supply from existing home owners who refuse to move and incur the cost of mortgages more expensive than their current ones.

Anyway, I will still point out that it was soaring shelter inflation that provided the signal to the Fed that rates were overly accommodative; the episode was a rare moment in Fed history where it acknowledge an inflationary problem from shelter costs. Historically low mortgage rates stoked demand and led to a mini-mania in the housing market. Prices soared practically uncontrollably for homes. Rent soared alongside home prices. I discussed the “housing trigger” for the Fed in “The Federal Reserve Fears On-Going Inflationary Pressures from Rents” and provided more detail in “Inflationary or A Bubble – Housing Prices Help Push A Fed Driving Recession-Pricing for Home Builders.”

I also provided evidence from a home builder about the impact of the Fed on cooling housing prices in “Lennar Corporation: How the Fed Is Cooling Inflation In the Housing Market.”

In other words, the mere fact that one-year leases on rents cause a lag in disinflation is insufficient to dismiss the various ways in which rent inflation forced the Fed to hike and to maintain its hiking campaign. A counterfactual on post-pandemic housing demand and prices in the face of prolonged accommodative policy should not be controversial: we have lived it three times in the span of just one generation.

Core Inflation

Stiglitz noted the following about headline inflation:

“The pandemic-induced inflation was exacerbated further by Russia’s invasion of Ukraine, which caused a spike in energy and food prices. But, again, it was clear that prices could not continue to rise at such a rate, and many of us predicted that there would be disinflation — or even deflation (a decline in prices) in the case of oil. We were right. Inflation has indeed fallen dramatically in the United States and Europe.”

This was a surprising sidebar when the Fed does not set monetary policy by what happens to food and energy. Adding to the distraction, Stiglitz does not label the inflation numbers her uses to compare to the Fed’s target. For the purposes of this discussion I will assume he is referring to core PCE (personal consumption expenditure, excluding food and energy) since it matches the number he uses for September. Yet, I cannot be 100% sure since the 3.7% change in the PCE in September matches the 3.7% headline change in the CPI (consumer price index) for September. This confusion is technically important because the median PCE sits at 4.4%. Core CPI was 4.1% in September, and the October report delivered the tiniest of cooling at 4.0%.

No matter the lens, these levels and incremental declines are hardly an occasion for final victory. While the Fed has every reason to stop hiking rates and watch what happens from here, these numbers do not tell me the Fed can pack up its toys and go home. Stiglitz takes care of that concern by calling the 2% inflation target arbitrary: “There is no evidence that countries with 2% inflation do better than those with 3% inflation; what matters is that inflation is under control. That is clearly the case today.” On the surface, the logic makes sense except that the period of “Great Moderation”, where deflation was the Fed’s biggest concern, was a period where PCE stayed below 2%. We do not have experience in THIS economy with a Fed that overtly allows inflation to stay well above 3%…and the Fed is clearly in no mood to push its luck.

Source: U.S. Bureau of Economic Analysis, Personal Consumption Expenditures Excluding Food and Energy (Chain-Type Price Index) [PCEPILFE], retrieved from FRED, Federal Reserve Bank of St. Louis, November 14, 2023.

Inflation Expectations

Stiglitz claims that the Fed also had nothing to do with controlling inflation expectations. Unlike the Fed, markets knew that inflation would naturally correct itself. Stiglitz even challenges the protest that inflation expectations remained calm specifically because of trust in the Fed: “…inflationary expectations remained tame. While some central-bank economists claim that this was due to their own forceful response, the data tell a different story. Inflation expectations were muted from early on, because markets understood that the supply-side disruptions were temporary.” Stiglitz took a debatable point and breathed unfounded certainty into it. Stiglitz focuses on the 5-year forward inflation expectation rate:

“Only after central bankers repeated over and over their fears that inflation and inflationary expectations were setting in, and that this would necessitate a long slog entailing high interest rates and unemployment, did inflationary expectations rise. (But, even then, they barely budged, reaching 2.67% for the average of the next five years in April 2021, before falling back to 2.3% a year later.)”

Yet, a different interpretation is plausible and valid regarding the stability in the 5-year forward expectation. It appears the market has a bias to expect disinflation (especially in response to shocks). Starting between 2015 and 2017, the market finally believed the Fed could hold inflation closer to 2.0%. This milestone came after persistent messaging, in different forms, from the Fed on the 2% target. It seems odd to blame the Fed for a brief spike in inflation expectations at the time the Fed started hiking rates. I find it more plausible to interpret the rapid return to previous levels as evidence the market was once again mollified over long-term prospects with a Fed clearly serious about constraining inflationary pressures.

Source: Federal Reserve Bank of St. Louis, 5-Year, 5-Year Forward Inflation Expectation Rate [T5YIFR], retrieved from FRED, Federal Reserve Bank of St. Louis, November 14, 2023.

Given it appears to take a lot to convince markets the Fed cannot control inflation over the “long-term”, I turned to shorter-term expectations as a more responsive indicator. It turns out that the 3-year consumer expectations peaked right as the Fed finally dropped the notion of transitory inflation in November, 2021. One-year expectations kept rising alongside inflation readings and peaked with a peak in inflation. Thus, it is very possible that the 3-year expectation more accurately reflects sensitivity to the Fed’s actions where it counts: consumers.

Source: Federal Reserve Bank of New York, Survey of Consumer Expectations

I go into more detail about the mechanics of inflation expectations in “Inflation Expectations and Inflationary Psychology.”

Since short-term expectations can start to bleed into longer-term expectations for inflation, the Fed took a risk management approach when it finally got serious about inflation. Tamp down short-term expectations and remove the risk of perturbing longer-term expectations which could prove harder to control above recent historical ranges.

The Risk Management Approach to Monetary Policy

The question is not whether or not the Federal Reserve should have acted to normalize monetary policy (by picking a non-zero target). The question is how far does/did the Fed need to go. Powell made it abundantly clear that the uncertain (and unprecedented) economic environment put the Fed in a risk management framework. The Fed decided it could not manage policy to the average or expected outcomes in the economy.

For example, a year ago, during the Q&A at a Brookings Institution conference, Powell claimed that monetary policy must take into consideration tail risks and their costs. The Fed collectively had decided that the costs of high inflation outweighed the potential risks of expeditiously hiking rates. The economy has proven so resilient that economists have spent over a year and half pushing out forecasts for a recession, a recession that could have been the main transmission mechanism for monetary policy to tank prices. Now, with the market celebrating the end of rate hikes and declaring victory over inflation, the runway is clear for the soft-landing narrative. I suppose those folks who think the Fed had no influence over inflation will have to conclude that monetary policy is totally meaningless if a recession is not forthcoming!

Conclusion

The inflation debate will never end because participants often bring to the table strong assumptions about the Fed’s capabilities and over-confidence in understanding the intricacies of the post-pandemic economy.

Ultimately, I stand by my long-standing claim that the Federal Reserve acted too slowly as supported by later economic research that I covered last June in “Why Monetary Policy Was Late In Responding to the Pandemic-Era Inflation Surge.” I stake no claim on the ultimate target; I just claim that the Fed needed to start normalizing sooner given what could be known at the time about economic conditions and the massive monetary and fiscal stimulus in the economy. Stiglitz did not explicitly say that he would have preferred the Fed do nothing, but his stance implies as much and feeds the narratives that inflation was never a problem in the first place. Thus, the Fed cannot satisfy anyone, not the inflationistas like myself nor the disinflationistas like Stiglitz….and certainly not the deflationists who held sway for so long going into the pandemic.

Be careful out there!

The post Despite the Inflation Celebrations, the Case Against Team Transitory Still Stands appeared first on Inflation Watch.

Source: U.S. Bureau of Economic Analysis, Personal Consumption Expenditures Excluding Food and Energy (Chain-Type Price Index) [PCEPILFE], retrieved from FRED, Federal Reserve Bank of St. Louis; February 24, 2023.

The chart above shows how the pandemic disrupted a serene post financial crisis range for monthly core PCE largely between 0.0% to 0.2%. Since PCE’s breakout two years ago (which the Fed ignored as transitory), core PCE has effectively settled into a higher range from 0.2% to 0.6%. Inflation may have indeed peaked, but it remains stubbornly high in the aggregate. The eagerly anticipated pre-pandemic serenity remains as elusive as ever.

Higher for longer inflation aligns with the Federal Reserve’s insistence on maintaining restrictive monetary policy higher for longer. The stock market may finally be catching on to the notion of higher for longer for inflation. When the core Consumer Price Index (CPI) came in hotter than expected in the previous week, the S&P 500 (SPY) wavered from intraday highs to lows and even increased the next day. Sellers took over the next 5 of 6 trading days with today’s 1.0% loss seemingly confirming a change in sentiment.

The S&P 500’s loss would have been worse except traders decided to defend support at the 200-day moving average (DMA) (the blue line above). This important trend line separates the index from more churn and a continuation of selling back down to the bear market line (20% down from the all-time high).

The bond market sniffed out the hotter inflation environment ahead of the stock market. Bond yields have steadily risen all month. For example, the iShares 20+ Year Treasury Bond ETF (TLT) is down 5.8% month-to-date (lower TLT means higher yields). The hot PCE brought an abrupt end to a 2-day relief rally in TLT.

Of course, the inflation story does not end here. The recent experience with inflation surprises suggests inflation will continue to confound the over-confident. A humbled Federal Reserve seems validated in taking a “risk management” approach to monetary policy in this haze of uncertainty. Still, if monthly core PCE takes a fresh drop next month, I am guessing a chorus will resume the inflation dismissals. If monthly core PCE continues higher from here, I will ring fresh alarm bells. I am watching the bond market’s next moves for potential clues. Moreover, I cannot wait to hear what the Federal Reserve and Chair Jerome Powell have to say about these developments in next month’s meeting!

Be careful out there!

The post An Inflation Downtrend Quickly Evaporates appeared first on Inflation Watch.