May 2023 Macro and Market Musings: Monetary Policy and Inflation

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May 17, 2023

Since early 2022, the Federal Reserve has been raising its policy interest rate at breakneck speed by a full five percentage points. Inflation has indeed subsided a bit, but both price levels and percentage changes remain stubbornly high. When will inflation finally go back to normal? What’s the path forward for monetary policy? Will there be a recession? So many questions! Let’s take a look…

Transitory vs. Permanent Inflation

I wanted to quickly bring up one issue that I believe is the source of a lot of confusion: the concept of transitory vs. permanent inflation. Is the 2021-2023 inflation shock transitory or permanent? It’s both! That’s because it depends on whether we look at CPI index levels or CPI year-on-year inflation rates. In the chart below, I plot the CPI (headline) index levels, i.e., the price level normalized to 100 for the 1982-1984 period. The most recent index reading is 302.918. If I had extrapolated a 2% p.a. post-2019 before the pandemic hit, then the index would be well below, at around 276. The actual CPI is now about 10% above that dotted trendline, which means we likely suffered a permanent 10% bump in prices (and likely more to come!).

CPI index levels: 2019 to 2023. Source: BLS.

Sorry to be the bearer of bad news, but not only will we likely never reach the old 2019 prices again, but we might also stay permanently above even the 2019 levels plus a 2% inflation trend. There is nothing transitory about that shock unless we believe that, over the next 2-3 years, we’d have significant deflation(!) to bring that CPI level down to the post-2019 trend line. As bad as the inflation shock may be, we probably don’t even want to go back to the pre-pandemic trend line because extended deflation like that is probably the effect of a major recession or even economic depression. Permanent inflation might be the smaller evil!

How about inflation rates?

The best we can hope for is that the growth rate of CPI will approach its long-term average of about 2% per annum again so as to not further diverge from the pre-pandemic inflation trend. But even that looks like a bit of a stretch right now. Annual inflation rates are still well above that magical 2% line; see the chart below. That said, we’ve made some progress toward reaching that 2% target again, at least if measured by headline inflation. Headline CPI peaked at 9%, now at 4.9%. Headline PCE peaked at 7%, now running at 4.1%. Hey, we’re more than halfway there! Also, notice that CPI numbers are available up to April 2023 and PCE only up to March. We expect the April figures on May 25, likely showing another small decline.

Four major inflation gauges: CPI and PCE, both in headline and core (i.e., ex-food&energy). Year-over-year growth rates. Source: BLS, BEA.

But here’s the bad news: despite some progress in the headline inflation numbers, core inflation is still stubbornly high. 12-month Core CPI peaked at 6.6% in September 2022 and is now only about a percentage point below that. And Core PCE, the FOMC’s preferred inflation gauge, peaked at 5.4% more than a year ago and still runs at 4.6% over the last 12 months. Even with inflation rates, we still seem a long distance away from getting back to normal and calling this pandemic inflation shock transitory. This brings me to the next question…

When will inflation subside again?

The worst-case scenario would be a permanently higher inflation rate. A recent WSJ article noted how rapid price increases might have become “entrenched” and how this might soon become a self-fulfilling inflation spiral. The good news is that the inflation picture isn’t quite as bleak as some folks want to make it. While the WSJ article makes some interesting points, there are also a number of trends underway that will soon put a dent in the inflation numbers. Hopefully!

First, the PPI (producer price index) is already almost back to 2% year-on-year; please see the chart below. Think of the PPI as the upstream inflation pressure, probably leading the CPI and PCE by about 3 months. And further, notice that this moderation in price pressures is broad-based. It’s not just due to energy prices; even the Core PPI fell from close to 10% at the peak in early 2022 to just above 3% in April 2023. So, the PPI headline is already where we need it, and the PPI core is already about 90% there. That’s some progress!

PPI Y/Y inflation. Source: BLS.

So, with the upstream price pressures abating, there is some hope that we, the consumers, will eventually feel the effects downstream as well. This artifact of final output prices declining only very sluggishly after input prices have already fallen even has a name in economics: “Rockets and Feathers,” which is often observed in retail gasoline prices. The price you pay at the pump goes up immediately when crude oil prices and wholesale gasoline prices rise (=the rocket). But on the way down, gas stations are lowering prices only very sluggishly (falling slowly like a feather). So, gas stations try to milk the high retail prices as long as possible, and this creates the intriguing fact that gas stations actually generate the highest profit margins when gas prices are on the way down. I suspect that we are now experiencing this “feathers” principle on an economy-wide scale. It’s not a huge surprise because this rockets and feathers effect has indeed been documented more broadly, not just in gasoline prices. So, it may be frustrating, but I suspect this effect is one of the reasons why the stock market has been holding up relatively well. Profit margins are very healthy right now, with strong final goods prices and input inflation back to normal. So, if you own stocks, take solace in the fact that you benefit at least a little bit from the ripoff at the pump and everywhere else in your consumption basket. And enjoy it while it lasts because, eventually, competitive forces will drive down prices again!

The second reason to be optimistic is that the next two CPI data releases for May and June 2023, to be published about mid-month in June and July, respectively, will likely show significant improvement, at least in the headline numbers. I wouldn’t be surprised if the year-over-year CPI took a significant nosedive over the next two releases because we’re rolling out the very strong price shocks in May and June of 2022 and replacing them with more normal monthly CPI changes. Expect a reading in the low-4s in the report next month. And by mid-July, when the June numbers are published, we could already observe a headline CPI number well below 4%. Probably somewhere around 3.5% and maybe even 3.3%.

The third reason has to do with rental inflation. Rents are another culprit for inflation being so sluggish on the way down. Rents are not set like gasoline prices or prices at the grocery store but rather very infrequently because rents are normally fixed for an extended period, often a year. The impact of this price sluggishness (also called “price stickiness” in economics) is apparent in the chart below, where I plot CPI and a few of its components. Note how the rent component seems to have an almost one-year lag vis-a-vis the overall CPI curve. For example, CPI had its pandemic trough in May 2020, but it took the CPI-rent another 11 months, until April 2021, to hit its low. Likewise, the overall CPI had its peak in June 2022, while rental inflation is only recently leveled off. Rental inflation, with its large share in core inflation, had been rallying over the past few months while some other components started to ease already. If rental inflation finally keels over and follows the economy-wide downward trend, we should see major improvements in the CPI and PCE numbers. Notice how CPI-less-shelter is already down to below 4% right now.

CPI Y/Y inflation. Source: BLS.

I also looked up the forecast of the 5-year average inflation rate implied by TIPS rates, i.e., the difference between nominal and real U.S. government bonds, and the rate is now down to 2.13% (as of May 16, according to Financial markets certainly believe that inflation won’t be lingering too far above 2% for too long!

Also, very noteworthy, food and beverage inflation is finally taking a nosedive as well. It’s good news for households with lower income who have been disproportionally impacted by the outrageous surge in grocery bills. Food inflation is also sluggish, not so much because of price stickiness but because of production lags due to agricultural growing/breeding cycles. And finally, medical goods & services, another heavyweight in the CPI, is also on a nice downward trajectory.

Who knows, maybe once rental inflation starts heading down, we’ll start worrying about disinflation again. This may explain why the Federal Reserve’s FOMC has slowed its rate hikes and may even pause at the upcoming meeting. And this also brings me to the next topic…

Monetary Policy

When I’m commenting on monetary policy, I’m always walking a fine line. If I’m too critical, people accuse me of having sour grapes with my former employer. If I’m too nice, people accuse me of being one of those evil central bankers peddling worthless paper money to unsuspecting Americans. So, let me start by stating that under the circumstances of being a little bit late with tightening monetary policy, the FOMC has so far done a pretty good job of raising rates and nudging CPI on its downward trajectory. If CPI and PCE decline as planned over the next few months, it would be quite an accomplishment for the Fed to thread the needle and bring down inflation without wrecking the economy, Paul-Volcker-style.

But not all is well in Fed-land. I’m worried about the Fed eventually messing up and snatching failure from the jaws of victory. I’m getting the impression that Fed officials are way too obsessed with the labor market and way too fixated on the impact of the unemployment rate on inflation. I went to graduate school to get my Ph.D. in economics in the late 1990s, and the Phillips Curve was dead back then. Who resurrected that rotting dead corpse in the meantime? True, nobody uses the old-fashioned Phillips Curve anymore, i.e., the level of unemployment correlates with the level of inflation. The newer iteration of the Phillips Curve comes in the shape of the NAIRU (“Non-Accelerating Inflation Rate of Unemployment”) concept, where the unemployment gap (actual vs. “natural” unemployment rate) is negatively correlated with the change rather than the level of the inflation rate. Applying this concept to today’s environment, the unemployment rate at a multi-decade low of 3.4% will create upward pressure on the inflation rate.

The NAIRU certainly has some intuitive appeal because low unemployment might create wage pressures and even raise inflation. But empirically, the NAIRU has been utterly debunked. Historically, the NAIRU has been so bad at predicting inflation that a naive random-walk forecast of the form “next year’s inflation = last year’s inflation” has a lower out-of-sample forecasting error than the NAIRU with all bells and whistles, as two of my former professors demonstrated. In fact, the recent decline of all the CPI, PCE, and PPI measures, all while unemployment is so low, demonstrates that the NAIRU is unreliable. Core inflation is so sluggish because of the rental inflation lags, not because of the labor market.

But the NAIRU voodoo economics is alive and well at today’s Federal Reserve. Read the speeches, press conferences, and testimony of FOMC members; they almost always tie inflation expectations to unemployment. For example, Governor Michelle Bowman, at a recent conference:

“Should inflation remain high and the labor market remain tight, additional monetary policy tightening will likely be appropriate to attain a sufficiently restrictive stance of monetary policy to lower inflation over time. I also expect that our policy rate will need to remain sufficiently restrictive for some time to bring inflation down and create conditions that will support a sustainably strong labor market.”

Michelle Bowman at a confrence in Germany. Source: Federal Reserve.

It’s almost like the FOMC misremembered the old and still valid Milton Friedman quote, “Inflation is always and everywhere a monetary phenomenon,” and now pins all the inflation dynamics on the labor market.

My concern is that the FOMC might cast aside all evidence on potentially moderating inflation in the coming months and feel the need to do more monetary tightening and/or keep rates high for longer than really needed, all to raise the unemployment rate. The danger is that they won’t believe their “lying eyes” on moderating inflation and rather manufacture a recession when they could have just sat back and lowered inflation without causing such harm.

There is certainly a great divide between market expectations and the FOMC “dot-chart” median path for the Fed Funds rate; please see the Fed Funds Rate expectations chart below. Futures markets predict declining rates much ahead of the FOMC’s expected timeline. Noted, the FOMC updates this chart only every second meeting, so this is still from the March 2023 meeting. But Chairman Powell, at the May 3 press conference, reiterated his view that there will likely be no rate cuts in 2023. I doubt that this chart will change much at the next release on June 14.

Fed Funds Futures vs. FOMC expected year-end rates.

So, let’s all hope that rental inflation finally drops in the coming months. Otherwise, the FOMC could be on a collision course with financial markets and the economy. Talking about the economy brings me to the next topic…

How’s the economy doing?

Knock on wood; the economy seems to be holding up so far. After a recession scare in early 2022 with two back-to-back quarters of negative growth (but no official recession declared), GDP has been growing again for three quarters in a row (Q3 2022 to Q1 2023). The second-quarter GDP reading will come out in late July, but that, too, is shaping up positively, with the Atlanta Fed GDPnow model currently tracking at 2.6% (as of 5/16/23).

The three business cycle indicators I always like to monitor are:

1: The Yield Curve Slope. That indicator looks scary! I use the 10-year minus the 2-year Treasury yield, and that’s currently at -0.52% (5/16/2023). In the past, an inverted yield curve has always signaled a recession. Not a good sign, I know, but this is what you get when the Fed raises short-term interest rate rates at that pace.

10Y minus 2Y Treasury Yield. Source: FRB St. Louis.

2: Weekly Unemployment Claims. They look decent so far. The level is still below 300k. Claims have risen a little bit, but that’s from record-low levels in the Fall of 2022.

3: The Manufacturing PMI. It currently stands at 47.1 for the month of April. Below 50 indicates contraction, but for a recession, we’d need to see a more significant dip below 50.

So, out of the 3 indicators I regularly follow, one is bad (finance/yield curve), one is good (labor market), and one is only so-so (manufacturing). Overall, that’s not screaming recession, but it’s not consistent with a completely healthy growth path either. It definitely signals below-average momentum for the economy. With a shaky economy like that, it makes it all the more important for the Fed not to overreact.


To conclude, lingering inflation is mostly due to price stickiness in rental inflation and the rockets and feathers issue, as outlined above. I cross my fingers that both effects will eventually run their course. We’ll arrive at more palatable inflation rates over time, certainly by 2024. The importance of the current low unemployment rate is vastly exaggerated. So, I’m more worried about what the Fed might do about inflation than inflation itself.

And that’s it for today! I hope you enjoyed my ramblings here and found some information that you wouldn’t find elsewhere on the web.

Thanks for stopping by today! I look forward to your comments and suggestions below!

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