Waller’s Case: Tariff-Driven Inflation Is Transitory

Just two days after Federal Reserve Chair Jerome Powell insisted that meaningful inflation is coming, Fed Governor Christopher J. Waller shared a nearly polar opposite narrative. Of course, given Waller may be on the short list of the President’s next pick to head the Federal Reserve, he has a built-in motivation to speak with authority in support of the administration’s claims that tariffs are not a threat to inflation. During a CNBC interview, Waller made the case for transitory and immaterial inflationary impacts from tariffs that would allow the Fed to start cutting rates as early as the July meeting. Waller explained that the Fed had paused for six months fearing inflationary impacts from tariffs that have yet to materialize. He chose to look through the ongoing uncertainty on tariff levels, timing, and frequency of change, as well as the recent Beige Book, which was full of accounts of businesses preparing for or already responding to tariff risks. Moreover, Waller claimed that only about 10% of the price index comes from imports (which made me wonder why there is any fuss over tariffs!). Instead, Waller expressed greater concern about the potential economic weakness caused by tariffs and stated he does not want to wait to cut until “we see a crash.”

Waller also referred to a speech he gave in South Korea in early June that laid out the detailed economic case for looking through tariffs as a one-time price shock. In “The Effects of Tariffs on the Three I’s: Inflation, Inflation Persistence, and Inflation Expectations,” Waller concluded that “the economics behind a tariff increase implies it should have a transitory effect on prices—tariffs raise prices once, but those prices don’t keep going up.” This conclusion holds if tariffs are hiked all at once in a one-and-done fashion. Otherwise, this reassurance reinforces the same argument Treasury Secretary Bessent made at the beginning of the tariff drama, trauma, and noise. Assuming that long-term inflation expectations remain anchored (as they are in market-based measures and professional forecasters, not in consumer-level surveys), Waller concluded “the tariff-induced inflation will be transitory and [the Fed] should look through it when setting policy.”

Powell’s Caution: Don’t Rush the Cuts

When Powell appeared on June 24th in front of the House committee to deliver the semiannual monetary policy report before the House Financial Services Committee, he was, of course, peppered with questions about tariffs and inflation. At one juncture, Powell took the opportunity to agree with Waller with an important condition (emphasis mine): “I do agree that basically if things are a one-time increase, then you don’t respond to them. That’s the whole idea if there’s a shock to prices… generally speaking you don’t respond if you are highly confident that it will just be a one-time shock.” Powell went on to caution that this particular situation is “a complicated one,” and said the Fed must make this decision about the timing of rate cuts “with some care.” He added that the Fed has not yet reached a point of price stability, and these large tariffs “raise kind of more concern” given the economy is just a few years out from a highly inflationary environment.

Powell’s caution appears warranted. Attempts to pattern-match to past history are challenging because of the scale and magnitude of the potential tariffs. The volatile implementation of economic policy means the Fed cannot be sure that tariff hikes will be a one-time episode. So, while a coming price shock may move inflation away from target, there remains some uncertainty about whether the Fed will be able to watch inflation settle back to target.

Bowman and Daly Lend Conditional Support

Vice Chair for Supervision Michelle W. Bowman added commentary on monetary policy in a speech the day before Powell’s testimony: “Assessing the Effectiveness of Monetary Policy During and After the COVID-19 Pandemic,” at a research conference sponsored by the International Journal of Central Banking and the Czech National Bank in Prague, Czech Republic. Bowman positioned herself as supportive of imminent rate cuts, although she did not specifically target July. Instead, she outlined broad conditions supportive of rate cuts: “If inflation remains near its current level or continues to move closer to our target, or if the data show signs of weakening in labor market conditions, it would be appropriate to consider lowering the policy rate, moving it closer to a neutral setting.” Bowman shared Waller’s concerns for the economy and stated that inflation appears on a sustained downward path to the 2% target:

“As we think about the path forward, it is time to consider adjusting the policy rate… we should recognize that inflation appears to be on a sustained path toward 2 percent and that there will likely be only minimal impacts on overall core PCE inflation from changes to trade policy. We should also recognize that downside risks to our employment mandate could soon become more salient, given recent softness in spending and signs of fragility in the labor market.”

Bowman expressed reassurance in the lack of inflationary impact from tariffs to date: “It appears that any upward pressure from higher tariffs on goods prices is being offset by other factors and that the underlying trend in core PCE inflation is moving much closer to our 2 percent target than is currently apparent in the data.” While acknowledging some upside risks for inflation, Bowman emphasized that she is “not yet seeing a major concern, as some retailers seem unwilling to raise prices for essentials due to high price sensitivity among low-income consumers and as supply chains appear to be largely unaffected so far.”

On Bloomberg Surveillance, June 26, Federal Reserve Bank of San Francisco President Mary Daly capped the dovish commentary by leaning toward the third of three timing scenarios for inflation:

1. Delayed, tariffs will have some impact and will be more persistent.
2. Delayed but will be one-off.
3. Does not deliver the punch history suggests will come as businesses absorb costs.

Daly stated that her “modal expectation” had been for some time that the Fed would be ready to cut rates in the fall. Thus her current dovishness is consistent with prior stances. Daly acknowledged tariffs “will potentially raise inflation.” However, since the impact should dissipate over time, it should not build into inflation expectations.

Rate Cuts, Politics, and the Fed’s Legacy

As the Fed’s debate about the impact of tariffs on inflation plays out, I am reminded that there is a larger context that influences how the Fed positions itself. The Federal Reserve was slow to respond to inflation in the throes of the pandemic, assuming that the price shock would be “transitory.” Even though he brought back the term “transitory,” even Waller revealed, “I am willing to admit that, at the time, I underappreciated how the large and sustained fiscal response would combine with highly accommodative monetary policy to overstimulate aggregate demand in an economy that quickly recovered from the early effects of the pandemic.” Waller is full steam ahead on team transitory again, while Powell continues to act like someone who still feels the scars. Powell’s caution makes even more sense in this context.

While Powell insists he is ignoring the political noise about his competence, his unwillingness to follow Presidential orders, and public ruminations about his firing or the looming presence of a shadow Fed Chair, Powell’s adamant stance sure has the appearance of someone trying to prove a point of toughness and independence. Thus, I fully expect Powell to be the “last one” to reluctantly move forward with rate cuts. I even expect his messaging at the time of the first rate cut to place responsibility squarely on the broader Fed… and to include some residual hawkishness of his own.

Overall, I lean toward Powell’s caution for all the reasons he gave to Congress. The environment remains highly uncertain, and the Fed has not yet reached its price target, even as a large price shock looms. Cutting rates in the midst of this swirling dynamic would signal a high degree of confidence in the post-shock equilibrium. Moreover, the Fed may have fundamentally different reads on the economy. For example, Daly insisted that “there are no warning signs that the economy is weakening, although progressing more slowly than before.” So if the Fed is both hampered by lower-quality data (due to federal budget cuts) and divided on the economy’s health, proceeding with rate cuts sooner rather than later seems doubly risky.

Conclusion

I will be highly surprised by a July price cut. Indeed, the CME FedWatch tool shows just a 21% chance of a cut, while September’s meeting has a 96% chance. These high odds essentially lock the Fed into cutting rates at the September meeting in order to avoid shocking the market. The messaging around that rate cut will be critical. Moreover, will the bond market get spooked and send long-term rates higher, just as it did both times the Fed cut rates last year?

The volatility index (VIX) sure looks incredibly low given the potential fireworks ahead. After breaking support from the dawn of the tariff drama, trauma, and noise, the VIX started this week right on top of that line.

Be careful out there!

Full disclosure: no positions

The post Powell vs. Waller: Divided Fed Faces Tariff-Driven Inflation Uncertainty appeared first on Inflation Watch.

As the stock market has careened into a bear market amid growing economic anxieties and uncertainties, financial markets have started to return to the old standby to save the day: interest rate cuts from the Federal Reserve. Expectations have definitively brought forward the timing for the next rate cut from July to June. The table below the chart of the market’s target probabilities for the June Fed meeting show the change in probabilities starting one month ago. The odds for the Fed maintaining its target rate range at 4.25% to 4.5% have plunged from 49.6% a month ago to 18.3% a week ago and 18.8% yesterday. While those odds moved slightly higher to 23.1% as of the time of writing, the odds for a 25 basis point cut still increased from 56.2% to 58.1% from yesterday to now.

Of course, if the market continues to roil and sink deeper into a bear market, financial markets may become too restless with a June timetable. However, as we saw last year, just the expectation for imminent rate cuts can be enough to keep spirits lifted in financial markets.

Even if the Fed wants to placate markets and play its modern role as market hero, consumer’s rising expectations for inflation should force the Fed to remain patient and measured. March’s preliminary read for the Surveys of Consumers from the University of Michigan showed yet another increase for both short-term and long-term inflation expectations. There is already a definite upward trend in long-run expectations and short-run expectations soared. From the University of Michigan:

“Year-ahead inflation expectations jumped up from 4.3% last month to 4.9% this month, the highest reading since November 2022 and marking three consecutive months of unusually large increases of 0.5 percentage points or more. This month’s rise was seen across all three political affiliations. Long-run inflation expectations surged from 3.5% in February to 3.9% in March. This is the largest month-over-month increase seen since 1993, stemming from a sizable rise among Independents, and followed an already-large increase in February.”

In parallel with the troubling trends on inflation expectations, consumer’s expectations for more unemployment are soaring. Take together, consumers are increasingly fearing a stagflationary economic environment.

Thus, the Fed faces maximum pressure. No matter what the Fed decides or says in next week’s decision on monetary policy, major disappointment and/or jitters are bound to rise from some significant portion of observers. In turn, elevated volatility could remain elevated and translate into more pressure on stock prices. Either the Fed will be taken to task for changing a re-ignition of realized inflationary pressures, or the Fed will be criticized moving too slowly to stave off a recession.

For now volatility is calming down as fears of a government shutdown subside…

…even as one of my favorite investments and trades, SPDR Gold Trust (GLD), breaks out to fresh all-time highs.

Be careful out there!

Full disclosure: long VXX put options, long GLD shares and call spread

The post Maximum Pressure for the Federal Reserve appeared first on Inflation Watch.

I faded the move in bonds as nothing about the December CPI print changed the fundamental narrative of sticky inflation and a cautious Fed or even the prospect of soaring U.S. budget deficits. I speculated on weekly SPY put options as a hedge. I fully acknowledge that the stock market has spent a year and a half or more adjusting to every hiccup and bout of angst over the inflation narrative.

The chart below demonstrates that the eye must strain hard to see a change in the profile of core CPI. We will have to wait until later this month to see whether the softer than expected core CPI also bends core PCE off its uptrend from its last trough.

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; January 15, 2025.

The volatility index (VIX) well represented the stock market’s huge sigh of relief over inflation. The VIX plunged 13.9% and brought an end to the most recent uptrend.

Shelter Inflation Continues Trending Down

Shelter inflation, along with services inflation, has been a key culprit in stubbornly sticky inflation. The National Association of Home Builders (NAHB) pointed out that “the year-over-year change in the shelter index remained below 5% for a fourth straight month and posted its lowest annual gain since January 2022, suggesting a continued moderation in housing inflation.” Shelter inflation has even been on a definitive downtrend since peaking in March, 2023. Unfortunately, the current trajectory may be too slow for comfort in terms of its impact on aggregate core CPI.

Shelter inflation dropped from 7.5% in December, 2022 to 6.2% in December, 2023 and now 4.6% last December. If this nearly linear pace continues, shelter inflation will be around 3.2% next December, right around where core CPI currently sits. Thus, other components will still need to do some heavy-lifting in coming months to meaningfully push core CPI, and presumably core PCE, closer to the Fed’s 2.0% target.

Source: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: Shelter in U.S. City Average [CUSR0000SAH1], retrieved from FRED, Federal Reserve Bank of St. Louis; January 16, 2025

An Oil Breakout

Oil prices are not part of the core CPI, but its recent breakout has caught my attention. A continued, persistent rise in oil prices could bleed into higher inflation expectations for consumers. Such a dynamic may further motivate the Federal Reserve to sit on its hands with monetary policy. A 3.3% gain in the United States Oil Fund (USO) sent the ETF to a 2 1/2 year high.

A Spike In Short-Term Inflation Expectations?

Every month, the New York Federal Reserve publishes a survey of consumer expectations. This survey includes various measures of inflation expectations. The 1-year median expected inflation rate for consumers stayed around 3.0% for all of 2024, consistent with the narrative of sticky inflation. However, a potentially interesting blip happened in December where the median point prediction jumped from 3.0% to 3.8%. The median point predictions are typically higher than the median expected inflation rate, but they rarely diverge and almost never by such a wide margin. The accompanying press release does not refer to this surprising 1-month behavior, but I cannot help speculating on its significance. I will be watching to see whether this point projection manages to lead the median expected inflation rate higher or whether it snaps back to the typical relationship. Either way, such a jump is surely not positive for inflation in the near-term.

The Trade

I continue to maintain a strategy of fading rallies in TLT. Going into the CPI I owned a single February TLT $85 put option “just in case” CPI produced a fresh upside surprise in inflation. Now I can accumulate TLT put options at more attractive prices. TLT’s rally stopped just short of resistance at the 20-day moving average (DMA) (the dotted line below). A breakout from there will set up even more attractive prices on a test of converging resistance between the downtrending 50DMA (the red line) and the bottom of the former trading range (the thick black line).

Be careful out there!

Full disclosure: long TLT put options, long SPY put options

The post A Fresh Opportunity to Fade Bonds As A Marginal Change in Inflation Ignites A Near Oversold Market appeared first on Inflation Watch.

Nevermind that a read hotter than consensus has little impact on the current trend. The chart below from the U.S. Bureau of Labor Statistics shows that even as core CPI (all items less food and energy) is flattening out a bit (the red line), the “sticky” shelter component of inflation is still hurtling downward (the purple line).

With the trend still favoring the death of inflation, I think of “sticky” as a reference to people’s impatience with an inflation component taking too long to converge with the overall average inflation level. The CPI report highlighted the relative stubbornness of shelter inflation:

“The shelter index increased 0.6 percent in January, and was the largest factor in the monthly increase in the index for all items less food and energy. The index for owners’ equivalent rent rose 0.6 percent over the month, while the index for rent increased 0.4 percent. The lodging away from home index increased 1.8 percent in January…The shelter index increased 6.0 percent over the last year, accounting for over two thirds of the total 12-month increase in the all items less food and energy index.”

The bubble chart below from the U.S. Bureau of Labor Statistics shows the outsized influence of services less energy services on total inflation (the large purple bubble). This major component includes shelter. Its relative importance of 60.9 dwarfs the relative importance of all other major components of inflation.

Given the angst directed at the shelter component of inflation, I looked at what the National Association of Home Builders (NAHB) had to say about this CPI report. The industry group provided a reassuring conclusion: “the NAHB forecast expects to see shelter costs decline further in the coming months.  This is supported by real-time data from private data providers that indicate a cooling in rent growth.” So while the housing price picture is mixed with existing homes on the uptick and new homes on the downtick, overall rents should continue a cooling pace as expected.

Unfortunately for those traders and investors buying stocks and bonds in anticipation of rate cuts, this reminder of inflation’s stickiness pushed out expectations for the first rate cut from the Federal Reserve. Over-eager financial markets pushed out the first rate cut from May to June. This is a bitter pill to swallow for those who started buying stocks and bonds late last year in anticipation of a rate cut in March (because the Fed admitted to inflation’s death of course). The chart from the CME FedWatch Tool shows how the odds favoring a May rate cut immediately evaporated.

The Fizzle and Sizzle in Financial Markets

Interestingly, currency markets and the bond market have been moving counter to the rallies in the S&P 500 (SPY) and the NASDAQ (COMPX). The 2024 rally in the U.S. dollar index (DXY) has taken the index ABOVE the point where currency traders dumped the dollar in the wake of inflation’s death. The chart below from Tradingview.com shows a bullish breakout for the dollar last month above its 50-day moving average (DMA) (the red line) and a successful test of the trend line as support earlier this month.

The dollar’s rally complicates my bullish trades on the Canadian dollar but also provides my latest opportunity to fade USD/CAD (Invesco CurrencyShares Canadian Dollar Trust (FXC)) within the trading range. I am net long the U.S. dollar by being short EUR/USD (Invesco CurrencyShares Euro Currency Trust (FXE)).

Excluding a sharp countertrend rally at the end of January, iShares 20+ Year Treasury Bond ETF (TLT) has sold off most of 2024.

These trends further reinforce the notion and fear that perhaps earlier rate cut expectations were indeed premature. After the market’s pullback (the S&P 500 lost 1.4% and remains in an uptrend) will stocks also concede the point or will they return to ignoring deteriorating market breadth and other signs of caution in the stock market?

The volatility index (VIX) may have already blown off enough steam to soothe the groans of the bulls…for now. Note carefully how the VIX stopped going down this year and thus has an ever so slight uptrend going…

Be careful out there!

Full disclosure: net long U.S. dollar

The post From Inflation Fizzle to Sizzle appeared first on Inflation Watch.