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The CPI report for September revealed that inflationary pressures remain muted. To date, weak inflation numbers have not deterred the Fed from hiking rates, but instead moderated the pace of rate hikes to gradual. I expect this will continue to be the case. Does this mean the Fed has gone crazy?
Core CPI inflation was again soft in September; the annualized one month gain was just 1.4%. The annual change remains above 2% (remember that PCE not CPI is the Fed proffered price gauge; in, recent year PCE inflation has been running below CPI inflation) but will roll over further if these soft monthly numbers continue. Shelter inflation appears to be moderating again: The pickup earlier this year was a bit of a surprise to me given reports that rent growth was slowing across many major metro areas. Consequently, I have been anticipating that the gains would not hold. Excluding shelter, service sector inflation firmed in September after a string of meager gains: What I find most interesting is that goods inflation has been very soft in the past two months despite tariffs and higher labor costs: This of course runs counter to the narrative that tariffs will become an excuse to push through higher prices to consumers. What’s going on here? Higher labor costs and higher material costs have to show up somewhere. If firms can’t push those costs through to final prices, then they show up in faster productivity growth or softer margins. This tweet from CNBC reporter Joumanna Bercetche:
Fascinating chart from @MorganStanley : The street is expecting margin expansion in every single US sector in 2019.This at a time of rising labor costs (wages) &raw materials (see PPG earlier this wk) No wonder we’re seeing #equities re-rating as more companies cite cost pressure pic.twitter.com/qYkUUFlOuW
— Joumanna Bercetche (@CNBCJou) October 11, 2018
suggests that analysts anticipate firms will be able to manage cost pressures through with a mix of the first two options (pushing through costs or higher productivity). But if the Fed continues to take a hard line on inflationary pressures, then it has to be productivity or margins. And if underlying productivity growth remains mired at roughly 1% give-or-take, then the cost pressures will reveal themselves in softer margins.
I think the Fed would be broadly happy with such an outcome. Optimally of course, they would like faster productivity growth. But the second best outcome is margin compression over inflation, which has the added benefit of tempering equity price gains. Enough pressure to keep inflation in check and ease the pace of job growth, but not enough to tip the economy into recession. Kind of a sweet spot for the Fed.
But should the Fed be raising rates at all given the weak inflation numbers? Shouldn’t they be rapidly lowering estimates of the natural rate of unemployment instead? Has the Fed gone “crazy” as President Donald Trump claims? Jared Bernstein noted that I dodged that question in yesterday’s post:
That’s all well and good, but just answer the question: has the Fed gone crazy or not?! (that’s snark, in case it wasn’t clear…I actually think there’s a great, albeit wonky, SNL skit in there somewhere–“Crazy Fed goes crazy!!”)
— Jared Bernstein (@econjared) October 11, 2018
Yes, I did dodge that question. I try, although not always successfully, to contain my work to “what will the Fed do” rather than “what should the Fed do.” I think I am more effective at the former if I divorce it from the latter. And if you are a market participant, you are probably looking for the former not the latter.
That said, I do have an opinion on this. My suspicion is that in the absence of rate hikes, inflation would be higher now and potentially high enough to be a threat to price stability. I don’t think you can use low inflation now as a reason to argue that the Fed should stop hiking rates because those rate hikes probably contained inflation. I think we are now too far along in the cycle to have not raised rates.
Moreover, I see room to raise rates further. Earlier this year I was worried that the Fed would deliberately invert the yield curve in their campaign to hike rates. I would view such an action as a policy error. Since then, however, the long end of the curve has sold off producing a bit of a bear steepening. This strikes me as an indication that the economy can indeed sustain the Fed’s rate path.
Finally, I am somewhat nervous that even in a low inflation environment the Fed appears fairly resistant to the idea that they should pause at something close to neutral to take a look around and wait for a bit more of the lagged impact of past rate hikes to work their way through the economy.
Speaking of crazy, Trump doubled-down on his Fed criticism today, saying the Fed is “out of control.” Trump did add that he didn’t expect to fire Federal Reserve Chairman Jerome Powell, but of course that threat is now out there (although the Fed Chair supposedly can only be fired for cause).
I do not think that this criticism will induce Powell to hike just to prove a point; Powell is going to be the adult in the room. Trump is looking to lay the blame for any slowdown in activity on the Fed, and has made itself a sitting target for such a game. The Fed’s forecasts very clearly show that central bankers intend to guide the economy into a slower growth trajectory. Now yes, we all know they believe such a policy path reduces inflationary pressures and actually extends the life of the expansion, but such nuance will be lost when the economy does slow.
Moreover, don’t forget that Trump knows how to work the press. This story gets him the attention he craves. So he will keep at it.
Bottom Line: Inflation remains low. Does this mean the Fed’s plan is crazy, or that it is successful? Looks more like success than craziness in my opinion. Regardless of that opinion, the Fed looks likely to keep following the path they laid out – gradual rate hikes until the economy looks likely to revert back to what they think is a sustainable pace of growth.