Macro Insights 07 29 2024

Welcome to Inflation V – Be 2 or Not Be 2?: That is the Question for the Fed

John H. Welch

Research for Emerging Markets

29 July 2024

Summary

·        Is the Fed’s inflation target 2 or not?

·        Everything points to 2.5-3.5%

·        Not going for the target hurts the Fed’ partially regained credibility

·        The rate of descent in inflation has slowed dramatically

·        Easing under may circumvent further inflation declines as in the 1970s

Market Implications

·        We are now in on our perhaps fifteenth false bond rally.

·        Yes, we are near an inflection point and that explains the downward trend in the long-term part of the curve.

·        If the Fed does not loosen -- I expect ­­-- we are going to get another sell off.

·        But hopefully inflation will continue to fall into 2025 when we should get a real bond rally.

Introduction

I am puzzled every time I hear someone say the Fed may cut rates in September. Perhaps they will, but I do not see any strong reason for this. Is the economy on the brink of a major recession? No. Is inflation or inflation targets expectations at the target of 2%? No. Has the Federal government corralled its huge fiscal deficit and the prospects of the future? No. Does the Fed like to move in an election year, especially in the third quarter if they do not have to? No. Then, I do not see the urgency in cutting rates and if they do it may repeat to a lesser degree the mistakes made in the 1970s. To make my case let us first look at the current inflation rate.

Current Inflation: Not at 2%, Improving Ever-So-Slowly

Current inflation rates have fallen the rate of decline is either stalled or significantly slowed. The existing trends look like inflation continues to decline but at an excruciatingly slow pace. Neither CPI nor core CPI nor PC nor core PCE nor core PCE service inflation are at the 2% target. In fact, they are at least 50 basis points away and in some cases above 3% (Charts 1 and 2). The BES just released June 2024 PCE numbers with headline inflation virtually unchanged from 2.6% y-o-y to 2.5% and core PCE as literally unchanged at 2.6%. Core service inflation fell marginally from 3.97% y-o-y to a still high 3.89% compared to the 2% target. All remained well above the 2% target. The next section looks at a couple of measures of inflation expectations that also continue significantly above 2%.

Chart 1: Headline and Core inflation (%, y-o-y)

Source: BLS, FRED

Chart 2: Headline, Core, and Core Service PCE inflation (%, y-o-y)

Source: BEA, FRED

Table 1 June PCE: Inflation’s Slow Decent

Source: BEA

Looking at table one, some analysts see signs of continued deceleration and inflation. In fact, there are signs of deceleration but also there are signs of reacceleration and signs of stagnation. PCE core inflation shows deceleration while PCE has stagnated at2.98% annualized and is higher than the year-on-year debt figure of 2.51%. Tome, the evidence is mixed and does not provide strong indications that inflation is converging to the 2% target. PC core services so-called “super core” fell back to 3.3% which is the same as y-o-y but lower than the six-month annualized figure of 3.83%. PCE core services accelerated and decelerated but again it is well above the 2% target that the FOMC has in mind. Even looking at the glass half full, these numbers do not transmit at least to me confidence that inflation is converging to 2%.

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Inflation Expectations: Not at 2%

Measuring inflation expectations is not an easy task. There are various surveys we will only present one here and then we will look at inflation break evens from the tips market and the US treasury market. Here, we will only look at two of them. Chart one shows 12 months ahead inflation expectations from the University of Michigan monthly survey. Very clearly current expectations are above the 2% target in fact they. Expectations were declining briskly and then stopped. It is hard to see how the Fed is comfortable with the trajectory of inflation declining to 2%.

Chart 3: University of Michigan 12-month Ahead CPI-U Inflation Expectations

Source: University of Michigan, FRED

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Chart 4: 5- and 10-year Inflation Break-Evens

Source: FRED

Labor Markets

Back in July 2021, I asked how late is the Fed? The answer was at least 15 months late because they had not even started raising rates. I estimated these long and variable lags, if they had started tightening then, to be at least 15months, but they would have had to go to a tight stance. Indicators show that the Fed has only recently turned marginally tight.

Chart 7 US: Job Openings per Unemployed Person

Source: BLS, FRED

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Real GDP Growth Continues Strong

As I was finishing this essay, The BEA released second quarter preliminary real GDP figures –up 2.8% annualized and they came in strong well stronger than expectations­ 2.0%.

Chart 8 US: Job Openings per Unemployed Person

Source: BEA

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Easing Before a Presidential Election? Only In an Emergency

Of course, 2024 is an election year. When I was at the Fed in 1992, it seemed clear that Alan Greenspan wanted to make sure that everything was in place in 1991 before the presidential election so he would not have to move. The Fed wants to be invisible during election years, especially 2024. One of the candidates Donald Trump has indicated that he wants the Federal Reserve to come under the Executive Branch. Other than the sheer folly of such a policy, if the Fed lowers the Fed funds rate before the election, expect a massive storm of criticism from the Republicans saying the Fed is trying to get the Biden administration reelected. This would threaten the independence of the Fed.

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Chart 8: Fed Funds Target Changes in Presidential Election Years

Source: Federal Reserve and REM, Inc.

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The Fed's behavior also indicates this pursuit of appearing invisible during election years. Chart 8 shows changes in the Fed Funds rate in presidential election years. In table 1, we summarize the number of easings and tightenings in each election year because Chart 8 is a little difficult to discern Fed actions.

Both exhibits show a reluctance for the Fed to act in election years. But that does not mean they do not act in extreme circumstances. The higher concentration of Fed actions occurred before 1988, that is, before Alan Greenspan became Chair in1987. In 1984 they eased four times and tightened eight teams before the election. In the 3Q1984 before the election, they eased three times and tightened four times. The volatile Fed policy changes were no doubt caused by the continued fight against the earlier high inflation by Paul Volcker’s Fed and the consequent volatility in interest rates and monetary base growth. In1988, the Fed eased two times all in 3Q before the election and tightened five times, two of which were in 3Q.

By the end of the decade, the Fed had regained its credibility and monetary policy normalized allowing the Fed to disappear before the election, an implicit goal of the Greenspan FOMC. Attacks on the Fed’s independence, historically commonplace, had escalated. The less the Fed appeared in an election year, the better for the Fed. THE Fed only tightened twice in the 1992 election year –all in 3Q -- but did not ease. Some blame the Fed for George H.W. Bush's defeat that year. I will leave that for others to discuss but I find it highly unlikely. The Fed was merely trying to normalize loose monetary policy that had resulted from the thrift crisis in southwestern United States, if I remember correctly.

Table 2 US: FRB Changes in Fed Funds Target During Presidential Election Years

 Source: Federal Reserve and REM, Inc.

The only other election years where the Fed was active were 90 2008 and 2020, years where the US economy faced huge uncertainty and cataclysmic repercussions of a financial crisis and a pandemic. The US economy does not face an emergency. We are not on the precipice of a large recession, nor a financial crisis and the inflation rate is not yet at the 2% target. The rate of descent has slowed dramatically and easing now might cut off this decline as it did in the 1970s and further reductions in inflation.

Other Indicators Still Show Somewhat Lax Financial Conditions

Updating the National Financial Conditions Indexes published by the Federal Reserve Bank of Chicago, on the other hand, still show financial conditions as loose (Chart 9). All this indicates that the Fed ‘pause’ is, at best, premature. In fact, in fact, financial conditions and monetary conditions have eased since earlier this year. This indicator might be flawed but then again, the banking system is well capitalized and underleverage so a huge tightening of financial conditions despite tighter money does not seem in the offing. This might even reflect a McKinnon Shaw effect, or higher interest rates create more liquidity and better financial conditions as banks are more likely to lend at higher rates individuals are more likely to keep money in bank deposits and short-term bonds.

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Chart 9: National Financial Conditions Index

Source: Federal Reserve Bank of Chicago

Another way to look at monetary conditions is using a concept that analysts applied to emerging markets, especially Latin America, called monetary overhang (Chart 4). This looks at cumulative growth in the monetary base. In other words, it shows how any monetary base surge moves into price increases. This overhang currently stands at 37%. The overhang peaked at 175% above the level in January 2020 in 3Q2021. Inflation has lowered the overhang to 15% in June 2024. Some of this money creation should have found its way into real GDP growth but cumulative nominal GDP growth since 4Q2019 is only 7.4%. That means we still have some overhang that will likely translate into further modest price increases. If there is still monetary looseness still in the financial system and the economy, the time does not appear as propitious for monetary easing just yet. That does not mean that we are not close to an inflection point but I think that change waits until2025 for easier money to prove sustainable and persistent. ‍

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Chart 10: US: Monetary Overhang – Cumulative Growth in Real Monetary Base

Source: Federal Reserve, BLS, and REM, Inc.

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Market Implications: The Bond Market Catches On

The market for US Treasuries is currently discounting a high probability of a September rate cut. We are currently in the 15th bond rally since the beginning of 2022 by my count as many analysts insist. Not even stagnant PCE inflation and strong employment numbers despite the economy operating at near or even above full employment. Chart 11 shows the US Treasury 10-year note rate in nominal and real terms.

Chart 11: 10-year US Treasury Note Yields

Source: Federal Reserve and REM, Inc.

We can see this in Chart 12 where disinversion (steepening) of the US Treasury curve is evident. We have a hump in the curve as the 10-2s spread is now close to zero while the 10s-5 is still inverted. The huge Treasury issuance to finance large budget deficits has added fuel to the curve steepening.

Chart 12 US Treasury Note Slope

Source: Federal Reserve and REM, Inc.

In this environment, we would keep our powder dry and buy the 10-year is we get another back-up on “disappointing” economic strength and labor market tightness. We would also recommend keeping a steepener ­– whether bull or not – selling US 10-year and buying US 2-year bonds.

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