Inflation & Interest Rates: share your data sources, models, and assumptions

[ChpBstrd]

LOOONG post for economics nerds:

The stock market corrected in the first quarter of 2022 in reaction to a rapid change in market expectations about how soon the Federal Funds Rate would be hiked, and how soon the Fed would reduce its $9 trillion balance sheet. It's fair to say the path of our investments for the next couple of years is mostly dependent upon the next handful of inflation readings.

The purpose of this post is to gather links to data sources which could help us learn more about forecasting the short-term future of inflation, and watch as the variables change over the pivotal next few months.

The key question seems to be: How long will we experience higher monetary velocity caused by the unprecedented stimulus of the $2.2T 2020 CARES Act, the $1.9T 2021 American Rescue Plan, and smaller stimulative acts of the past two years? Will the extra money in the system quickly find its ways to overseas reserve banks and the stagnant accounts of rich people holding US Treasuries, and out of circulation in the real economy? Or will most of the money keep bouncing around in the real economy, contributing to monetary velocity for years, and requiring even more rate hikes than the market expects?

At the time of this OP, the market has priced in the following inflation expectations, which I would characterize as rather tame compared to the inflation hype and headlines:

20 year: 2.81%. Source: https://fred.stlouisfed.org/series/T20YIEM
10 year: 3.02%. Source: https://fred.stlouisfed.org/series/T10YIE
7 year: 3.14%. Source: https://fred.stlouisfed.org/series/T7YIEM
5 year: 3.41%. Source: https://fred.stlouisfed.org/series/T5YIEM

This means the bond markets (typically the smartest and most accurate forecasters in the investment world) are expecting:

     a) Severe Recession Scenario: a massive disinflationary recession within the next couple of years that will cause the 5-year average inflation to fall to 3.4% despite today's 8%+ inflation readings (e.g. 3.4% = AVERAGE(8%,0%,3%,3%,3%), OR...

     b) Transitory Scenario: a rapid collapse in inflation - the "transitory" narrative but on a longer time scale than people were thinking last year. This would be because we went from $4T+ stimulus and QE in the last couple of years to zero all of a sudden in 2022, with rising interest rates too, and about a year of lag time (e.g. 3.4%=AVERAGE(8%,2.2%,2.2%,2.2%,2.2%). This would be the "soft landing" scenario in which monetary velocity returns to the existing trendline. OR...

     c) Fed Overreaction, a scenario in which inflation collapses for its own reasons at the same time as the Fed tightens policy and we're close to recession/deflation again in 12-24 months. In this scenario, the Fed has a delayed overreaction to what would have been transitory inflation. They ignore the short-term causes (stimulus legislation, commodity shortages) and tighten money supply just as the economy is slowing anyway. Recession occurs and rate hikes are stopped at about the level the bond market is predicting.

Caveats
These simple scenarios do not, of course, account for the possibility of a financial crisis as bank assets devalue (guess who suffered the epic bond losses of the past 6 mos?), a real estate crash causing a repeat of 2008, or a sovereign bonds crisis in highly leveraged countries. They also do not account for potentially rapid earnings growth, improving logistics, and the full employment we are currently experiencing. So the portfolio consequences might not correlate 1:1 with interest rates.

The transitory scenario seems like the only one with the potential for a positive stock market outcome, such as would occur if earnings growth and a rapid decline of the inflation rate both overwhelmed the effect of higher rates or reduced everyone's expectations for future rate hikes. Markets had a little rally in March when the inflation trajectory seemed to be flattening, because if inflation started going down then the Fed might not end up hiking much after all. We will know by THIS SUMMER if the transitory scenario is happening.
Core CPI: https://fred.stlouisfed.org/series/CPILFESL#0

Historical Accuracy of the Bond Market in Predicting Inflation
The last time there was a big gap between CPI and inflation expectations implied by TIPS yields was 2007-2008. Back then, the bond market held its 10y expectations in the 2.5% range despite month after month of inflation readings in the 4-5% range. The bond market was right about inflation coming down soon. When the deflationary financial crisis actually hit, TIPS and regular treasuries suddenly started trading at the same yields, and so the market briefly predicted 0% average inflation for the next decade (i.e. a worse economy than the great depression). Other than this error, the bond market has been a fairly accurate inflation trend forecaster for decades. Today, the bond market appears to be expecting inflation to come back down quickly, just like in 2007-2008. However the gap between forecasts and actuals is much bigger than in 2007!
Historical Predictions vs. Actual Source: https://www.yardeni.com/pub/expectinflat.pdf figure 3

Personal Consumption
On the flip side, the Personal Consumption Expenditures metric (set to % change from year ago) suggests consumers are still spending like drunk sailors. You can practically see the arrival of stimulus checks on the graph, and the effect of all that money ricocheting throughout the economy. PCE is holding up so far in 2022, suggesting the stimmie checks have not yet all made their way to China. So inflation could continue a while.
PCE Source: https://fred.stlouisfed.org/series/PCE#0

Savings Rate
The counterpoint to this argument is the observation that the Personal Savings Rate has plummeted to below the pre-COVID trend. Maybe consumers are flush with stimulus cash, feel secure in their employment, and don't feel the need to save any more? Or maybe they have already blown through their stimulus cash and are now spending out of their savings jars? Or maybe they're not saving as much because they're buying stuff now in anticipation of rising inflation later. In any case, maybe consumers don't have a pile of savings to sustain their current spending spree? The high savings rates during 2020-2021 were a bullish sign, but now we've gone the other direction. This supports the case for falling monetary velocity.
Savings Rate Source: https://fred.stlouisfed.org/series/PSAVERT

Inventories
Will inventory shortages continue to prop up prices? Not according to this chart. Businesses seem to have recovered from pandemic-era logistics and manufacturing challenges, and inventories are now back on the trendline. This supports the case for falling inflation.
Inventories Source: https://fred.stlouisfed.org/series/BUSINV

Money Supply
Money supply charts show the $4T stimulus as an increase above the trendline of... about $4T. The Fed is now discussing selling about $95B per month of its assets to reel in some of this excess money from the economy. They could flatten the growth of M2 like they did in 2009-2010, which would contribute to low post-stimulus inflation just like it did in 2009-2010. I don't think M2=inflation like some of the internet simpletons who were calling for hyperinflation in 2011 and haven't changed their theory to match the facts, but I do think rapid growth or contraction in M2 suggests a change in monetary velocity. A flattening money supply like we can anticipate now implies low inflation in the future.
M2 Source: https://fred.stlouisfed.org/series/M2NS

Monetary "Leakage"
The rapid growth of money supply after the Great Financial Crisis led many people to think inflation would rise. A price bubble soon formed in the price of gold, spurred on by countless financial media articles, and then popped when the inflation failed to materialize. There are several reasons why rapid growth in M2 did not translate into monetary velocity. These reasons have been with the U.S. for decades and are only accelerating:

1) Demographic graying: We're now where Japan was in the mid-early 90's. Old folks spend their incomes more slowly.
2) Trade deficit: Foreign merchants accept USD as payment and then buy US treasuries with some percentage of the money. This essentially takes currency out of circulation in the domestic economy, reducing monetary velocity. The currency goes from the hands of consumers to merchants to the US government. The higher the trade deficit, the more cash is disappearing from the Main Street economy and going into treasuries.
3) Federal deficit: The 2020-2021 stimulus dwarfed the 2008-2009 stimulus, and it was also more directed toward consumers instead of banks. Banks hoarded the cash. Consumers blew the cash on housing and imports so quickly it caused severe shortages. In both cases, large amounts of money flowed from investors' hands into consumers' hands, but in the long run the flow reverses and consumers hand over their money to investors, who park it in treasuries. Once money is put into treasuries, it stops being used in transactions and might as well have stopped existing, as far as the real economy is concerned. These funds no longer contribute to transactions that aid price discovery.

These patterns can be expected to continue, and they are all disinflationary. This is why money supply does not equal deflation. This is why inflation was so low after the GFC. And this is why the stimulus of 2020-21 is rapidly leaking out of the real US economy.

Corporate De-Leveraging
Corporate debt increased in early 2020 and then corporations briefly went into debt-reduction mode before continuing to add debt. The value of all nonfinancial corporate debt over the value of all corporate equity just reached all-time lows, beyond even the lows seen in early 2000. It is simultaneously true that corporations have record levels of debt while at the same time they are de-leveraging. Both statements represent slices of a growing pie. In terms of inflation, it does not appear corporations anticipate a prolonged period of high inflation, but they are probably better positioned than 10 or 20 years ago to handle such a contingency. Corporations as a whole are raising prices at the rate of inflation, while generally the interest costs on their debt is not increasing as quickly as their revenue. However if inflation falls and rates keep rising, that process will go in reverse.
Corp. Debt Source: https://fred.stlouisfed.org/series/BCNSDODNS
Corp. Debt / Equity Source: https://fred.stlouisfed.org/series/NCBCMDPMVCE set to % change YoY

Government Spending
Federal expenditures are rapidly falling back toward a long-term trendline, despite the much-hyped infrastructure bill. This matters for monetary velocity because government spending accounts for about 38-40% of U.S. GDP. The rapid growth of 2020-21 occurred in part because governments spent a LOT of money, but that process is rapidly going into reverse. Government spending is falling, and that pulls down GDP and monetary velocity. Falling government spending increases the odds of recession and is disinflationary.
Fed Spending Source: https://fred.stlouisfed.org/series/M318191Q027NBEA
% of GDP Source: https://tradingeconomics.com/united-states/government-spending-to-gdp

Yield Curve
Flattened or inverted yield curves communicate that the bond markets expect a recession. Basically the bond markets are saying "I expect interest rates to be lower at some point in the near future, so I want to lock in today's rates on longer duration bonds before I lose the opportunity, as well as taking advantage of the appreciation of today's long-duration bonds when rates are cut." and everyone bids up the price for longer duration bonds while demand dries up for the shorter durations. An inversion of the yield for 10y and 2y bonds means a recession is very probable, and an inversion in the 10y and 3 month bond means it is certain and imminent. Right now we have a flat, but not inverted, yield curve, suggesting there is still some ambivalence in the bond market about whether a recession will occur or not. But another twist is that a rapid series of rate hikes are expected, so traders have to weigh their interests in staying short-duration so they can catch those higher rates against their interests in locking in rates before an expected recession. This suggests that market participants are assigning some probability - a decent amount actually - to the "transitory" scenario described above. If a sustained inversion happens, that means the transitory scenario has been dismissed.
Yield Curve Source: https://home.treasury.gov/resource-center/data-chart-center/interest-rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value_month=202204

Is There A "Neutral Rate"?
Multiple Federal Reserve Presidents have made comments about the existence of a "neutral" range of interest rates that is neither stimulative nor constrictive, and their desire to reach this point within the next several months. In theory, when interest rates roughly equal the long-term inflation target, the economy is set for steady growth without the risk of policy errors causing unnecessary and destructive swings. This is purely an ideological construct - an untested and perhaps unfalsifiable hypothesis that may not hold true for all economies in all times. But it appears to be the consensus at the Fed so we'd better pay attention.

If the Fed considers this to be the optimal policy point for maximizing employment and price stability over time, they will gravitate toward this as a goal, and perhaps disregard contrary evidence. If we're heading toward "neutral", which is actually a long distance away from our current position, then maybe it doesn't matter if the stock market crashes, unemployment rises, bond losses sink banks, etc. The Fed could keep chugging along toward their self-established goal. Their guidance about letting inflation run hot for a while to offset earlier periods of low inflation could evolve into letting economic growth run slow for a while so that we can reach "neutral" and enjoy the long-run benefits of being there. Similarly, it could be they are wrong and the "neutral" rate of interest is a useless, constantly changing variable they'll never pin down with interest rate policy. If that's the case, we'll see a march-at-all-costs to 2.25%-2.5% followed by reluctance to adjust from there. This is what set off the 2018 correction and scary overnight markets activity, and it sounds like the Fed wants to give it another go.
Source for Mary Daly: https://www.reuters.com/news/picture/raising-feds-policy-rate-to-25-by-end-of-idUSKCN2MC1CM
Source for Thomas Barkin: https://news.yahoo.com/feds-barkin-says-interest-rates-230514070.html
Source for Charles Evans: https://wdez.com/2022/04/20/feds-evans-repeats-view-he-sees-interest-rates-at-neutral-rate-by-year-end/

Stock Valuation at Various Interest Rates:
The S&P500's current PE ratio is 21.8. This is lower than the average (24.7) for January 1 dates during the last 30 years but is considerably higher than other times when the 10 year treasury yield was near 2.9%, such as 2019 (PE 19.6, 10y 2.71%), 2014 (PE 18.15, 10y 2.86%), and 1956 (PE 12.12, 10y 2.9%). Perhaps a "neutral" interest rate will yield a long-term average PE ratio? The earnings yield of (1/22=) 4.54% implies that inflation will be low for the foreseeable future and that stocks will continue to earn a very modest risk premium of maybe 1.5% over 10y treasuries. Stock holders are voting for a transitory outcome.
PE Source: https://www.multpl.com/s-p-500-pe-ratio/table/by-year
10y Yields Source: https://www.multpl.com/10-year-treasury-rate/table/by-year

A Caution on Inflation Dogmatism
If you truly 100% believe high inflation is with us for the next couple of years, you should drop what you're doing, sell everything right now, and trade bear spreads on TLT. Collect 50% compound returns per trade every 3 months or so for the rest of the year. If you're wrong, your losses will be 100%, but hey this strategy is for 100% true believers. Those who don't know how to trade options should buy SQQQ, a triple-inverse ETF, because growth stocks are going down as expectations change and we start to expect a Fed Funds Rate in the 4-6% range rather than the 2-3% range.

If you truly 100% believe inflation has peaked and is on its way down, then it's more complicated. Bond markets already assume inflation will peak soon and interest rate hikes will be limited, so there's no arbitrage opportunity. TLT won't necessarily go back up if the rate hikes stop at 2.25%, because it's already priced for that.

Stocks won't necessarily do well either, because the transitory scenario might or might not involve a recession. The Fed is likely to continue raising the rate target from their current 0.25% to at least 2.25% even if inflation starts falling precipitously later this year, and that will raise borrowing costs for corporations and their customers. Things that might work to "short inflation" while expecting a rise in interest rates would be to go long the US dollar (low inflation + high yields = attractive currency). Similarly it might be wise to establish a hedged position in stocks, because earnings growth might raise the E in "PE ratio" fairly quickly now that stocks have been discounted to match the future "neutral" rate of interest, and full employment has a way of supercharging earnings growth, while it lasts.

Either direction means massive losses if you're wrong. I don't think most people look at their portfolios this way, and say "Oh, looks like my portfolio is a big bet on transitory inflation and a soft landing." Similarly, I don't see the people most convinced that inflation is here to stay making the risky investments that would actually exploit that. There's a case to be made for a measured approach, accepting the possibility of being wrong, and waiting for clarity if necessary.

My Current Estimate
Judging by breakevens and PE ratios, it appears that few people in the stock or bond markets are anticipating interest rates going higher than the Fed's 2.25%-2.5% "neutral" rate. This outcome would still include the 3 possibilities listed above: recession, transitory, or overreaction. However the folks calling for stagflation or more than one year of inflation >5% are in the minority (financial media is really playing up these scenarios, but the markets don't reflect them). This does not mean the doomsayers are wrong. Recall that prior to the GFC, the bond markets were apparently forecasting a soft landing. Just like today. The bond market was wrong as recently as early January, and it could come to the realization it was wrong again.

The only "good" scenario for long investors not in the accumulation phase would be the one subset of the transitory scenario where inflation falls from the April 2022 peak, rate hikes are stretched out longer than was anticipated in April 2022, unemployment stays low, and earnings growth makes up for PE shrinkage. There are a lot of variable that must go exactly right, but it's also the most probable outcome (out of several outcomes, so not saying much).

I think the Fed's credibility was shaken by the last 6 months' inflation numbers and all the "behind the curve" criticism. I also think all this "neutral rate" talk means we're heading to 2.25%-2.5% whether hell or high water. This drive toward an arbitrary goal will give the Fed another chance to get "behind the curve" as the economy goes into a post-stimulus sugar crash while they continue raising rates. So my forecast is the "overreaction" scenario. There will be a mild recession or a 2018-style crash that scares the Fed into rate cuts again. 

Rate-hiking campaigns have historically been the most dangerous times to have market risk exposure. I could be wrong but when there are 8 ways to lose and one way to win, it's time for tightly-hedged conservative and cash-heavy portfolios. Even if we get the "transitory" scenario, and the Fed does everything right at just the right times to engineer a soft landing, it could all go to shite anyway when we discover that some financial institution is sitting on massive losses and can't pay counterparties.

Congrats to anyone who made it this far down the nerd hole. What data points, assumptions, or research am I missing?

[vand]

A big OP, ChpBstrd, and lots to digest.

I just want to say that I too was of the belief that bonds were the adults in the room, but on closer  examination it turns out the bond market is, in fact, a lousy predictor of future inflation, and tends to get it as wrong as anyone whenever there is a change in the secular trend.

https://www.piie.com/blogs/realtime-economic-issues-watch/bond-yields-are-not-good-predictors-inflation

[less4success]

A very interesting read. Thanks, ChpBstrd!

I doubt this changes your prediction or analysis, but I have one issue with the "demographic graying" factor you mentioned (and I've seen mentioned elsewhere on the Internet).

If you look at the US population structure (https://upload.wikimedia.org/wikipedia/commons/3/32/USA2020dec1.png), right now the biggest bulge is around 32 years old. If "spending by age" patterns hold (see BLS: https://www.bls.gov/opub/btn/volume-4/consumer-expenditures-vary-by-age.htm), then this largest (living) cohort is currently entering their prime spending years (for roughly the next 2 decades).

Also, just because I was curious, I looked at Japan's population structure in 1995, and it was much different (and more concerning) than the (2020) US one I linked above (Japan had a lot more middle-aged people and a lot fewer children, relative to the entire population): https://upload.wikimedia.org/wikipedia/commons/7/7f/Japan_sex_by_age_1995.png

Demographic graying is definitely going to be a trend in a lot of countries, but I don't think the US is going to look like Japan.

[blue_green_sparks]

Is there a new technological boom on the horizon to lift the economy? I fully expected green energy/green infrastructure to propel us into this century but that has been sort of disappointing so far. I think our future as a species is directly tied to it; yet we are still focused on the cost of fossil fuels and even funding wayward leaders who sell it.

[ChpBstrd]

Is there a new technological boom on the horizon to lift the economy? I fully expected green energy/green infrastructure to propel us into this century but that has been sort of disappointing so far. I think our future as a species is directly tied to it; yet we are still focused on the cost of fossil fuels and even funding wayward leaders who sell it.

That's probably more long-term than the next 2-3 years scope of this discussion, but I think working from home is going to change a lot of things:
-push up wages in rural / small town areas
-push down wages in HCOL urban areas
-push down real estate in HCOL urban areas
-reduce demand for oil (will be a bigger effect than electric cars)
-shift demand from cars and office buildings to home office / metaverse equipment
-flatten management structures because WFH actually takes a lighter management touch - less sexual harassment, less office politics, more focus on deliverables and output, fewer interruptions, less time wasted socializing / gossiping, less paper management, less facilities management, more meetings that could have been emails actually done as emails, etc.
-improved margins for companies that ditch their expensive physical offices / productivity gains
-less wasted time/money recruiting rare skills in a small pool of local employees
-better utilization of the disabled, sickly, or mentally ill workforce
-corporations will have a higher % of variable costs and a lower % of fixed costs, leading them to be more bold about making growth attempts and more willing to cut employees loose. More experimentation and upsizing/downsizing will result.
-because the variable/fixed cost ratio will be tilted more toward variable, corporate capital structures will be able to hold more debt than under the previous, physical office way of doing things. I.e. in a recession, the corporation can more quickly cut costs by reducing employees, and not have to pay rent on empty space or depreciation on cubicles and parking lots.

[blue_green_sparks]

I agree the work-from-home strategy is often more efficient. In fact, when I was in a real crunch, I would request to work from home even though it was not standard modus operandi yet. Eventually they did allow voluntary 9/80 and started "no meetings" Fridays but most of my former life as an engineer was 6-day weeks and 9 or 10 hours a day. That was my real motivation to become FIRE'd.

[Mr. Green]

I expect work from home and green energy mass adoption to come about the same way, only when we absolutely have to do it. I was hoping WFH would be more sticky coming out of the pandemic but the majority of large corporations just don't want to give up the office yet. One can only hope this reaches a critical mass.

[MustacheAndaHalf]

@ChpBstrd - Regarding that first post, I like the data driven argument and was concerned by it, as I mostly hold the view of higher inflation.  Hopefully even if you don't agree with my conclusions here, you find the inflation data a useful addition to this thread.

The U.S. Bureau of Labor Statistics tracks CPI-U (urban consumer inflation), and has summarized inflation for both March 2022 and the 12 months ending in March.  For inflation data, food & energy are the most important, but I include shelter so I can re-use subtotals at the bottom of their summary.  The March inflation x 12 is listed first, followed by the trailing 12 months.

Food: 12% March vs 8.8%
Energy: 231% March vs 32%
Shelter: 6% vs 5%
==> Total: 14.4% vs 8.5%
"All items less food, shelter and energy": 2.4% vs 7.5%
https://www.bls.gov/news.release/cpi.t06.htm
https://www.bls.gov/news.release/cpi.t07.htm
 
Oil prices spiked because Russia invased Ukraine, which is visible in the above CPI-U inflation data.  Russia is a major energy (oil & LNG) supplier to Europe, and both countries are major grain suppliers.  OPEC has maintained production - I think because they need the profits after years of low oil prices, with schadenfreude over Russia & it's customers being a bonus.  The Fed mentions indicators of peak inflation, which I think ignores the importance and direction of oil & food inflation.  I expect higher inflation to continue for more than 3 months.

Normally you should trust the Federal Reserve, but their mistakes are piling up.  When they claimed inflation can go up without jobs being impacted, they lost me - and the market is mocking them for it.  The stock market seems to take the Fed's word as gospel, while I'm committing the heresay of predicting what their god will do next.  Schwab's bond analyst presented a graph showing long-term treasury yields.  The average, median and mode were all 3%, which is the bond market prediction (up from 2%, without admitting the prior mistake?).  Like the stock market, they only seem to react to the Fed.  I hope I'm predicting conditions in advance, which in turn will change the Fed's data, and then that will be priced in by markets.

You mentioned SQQQ, which I avoid despite it's recent performance.  Half of QQQ holdings (AAPL, MSFT, AMZN, GOOG, FB, TSLA, NVDA) dominate their industries, and I'd like to avoid shorting those giants.
https://finance.yahoo.com/quote/QQQ/holdings?p=QQQ
https://finance.yahoo.com/quote/SQQQ/performance?p=SQQQ

I profitted off inverse bonds I held during March, and those inverse bonds had a similar profit so far in April.  Since I do not want missed April profits to drive decisions with FOMO and greed, I re-examined my March sell decision.  I am comfortable with it - there's no unresolved problem that investing will solve.  I sold in March because of a local maximum and the higher risk of a crash.  After I sold, the investment fell 9%, so I was correct to call a local maximum.

Back in Dec the market was greedy and ignored uncertainties.  Bonds and risky stocks got a surprise in Jan, and the CNN fear & greed index fell as bonds took a hit (and certain growth stocks).  In my view, crashes are drivenby surprisingly high negative sentiment.  Right now that fear & greed gauge registers "fear" (halfway between "extreme fear" and "neutral"), suggesting the elevated risk of a crash is well known - it's not a surprise.  So I view a crash as less likely until the market gets greedy again (as measured by CNN fear & greed index).
https://edition.cnn.com/markets/fear-and-greed

My biggest concern for inverse bonds is the risk of a stock market crash.  I think a crash likely over 2 years, but not over 2 months.  But this is a weak conclusion on my part, both because of weaker data and the greater uncertainty of when crashes occur.  In the event of a crash, it could play out like March 2020 where the Fed dropped rates from 1% to 0%.  That happened a full week before the market clued in to Covid-19, suggesting the Fed can act before the market even knows what happened.  In that event, I could take big losses in inverse bonds (mitigated somewhat, but not completely, but stop loss orders).

The FOMC (the Fed) meets on May 3, June 14, and July 26.  I bought a significant amount of inverse bonds Friday (Apr 22), and plan to hold them until sometime after the July 26th meeting.  I have no plans to report on my future decisions or progress.  If someone decides to invest similar to me, they're on their own.
https://www.federalreserve.gov/monetarypolicy/fomccalendars.htm

[ChpBstrd]

@MustacheAndaHalf the issue with thinking about inflation statistics, the CNN fear indicator, and market activity is that all these information sources are historical, or at best current. They don't tell us where inflation, sentiment, or prices will likely go next because they're telling us what is already priced in. Historical information sets the context for how we explain the world, but historical/current information also encourages us to extrapolate the continuation of current trends forever rather than predicting a reversal. A broader overview of historical data is "these zig zagging lines and trends reverse course all the time".

If the Fed was wrong about inflation in the 2nd half of 2021, then so were the stock and bond markets (me included in that herd of lemmings). Sometimes being in the herd can give us a false sense of security. We need leading indicators, not trailing ones. And we also need a model that will suggest what happens next. Markets are routinely wrong, so if you want to be right at the same time the market is wrong, you need the right data and the right model.

For example, a stock-savy Keynesian economist might have seen in 2009 that the government was doing all the right things to prevent a depression, and that equities were underpriced because the "herd" was moving in a "probable depression" direction. They would have been in the minority with their prediction of growth in 2010 but that's because trends were about to reverse. The people still talking about Lehman and AIG long after that news had hit and those outcomes were priced into the market were the ones left behind. The people with bunk economic theories (ahem... Austrians predicting hyperinflation) were left behind in the wilderness as the stock and bond markets began an epic, decade-long bull. So having the right model accounts for a lot!

The leading indicators I think influence the future path of inflation include:

Government spending - currently in decline, which is dovish for inflation
Money supply - flattening, which is dovish for inflation
Personal Savings Rate - currently in decline, which is dovish for inflation (high savings during the pandemic predicted the consumption spree driving up current prices)
Inventories - back to normal, which is dovish for inflation (low inventories during 2021, amid a stimulus-fueled consumption frenzy, caused prices to rise. But now things are back to trend)
Yield Curve - This is both a current metric and a self-fulfilling predictor of future bank lending. Flat or inverted curves force banks to stop making loans because they can't make enough profit off the term spread. The yield curve suggests rates will peak near the Fed's "neutral" level, although the Fed is heading there regardless of all other outcomes. Nobody seems to be predicting continual high inflation that would force rates to keep going higher.
Trade Deficit - When money goes overseas, it is often recycled into long term investments like treasuries and effectively exits the main street economy of frequent transactions where price discovery occurs. This is how money supply leaks from the U.S. economy. The deficit is high, suggesting that the recent increase in money supply is exiting the real economy at a fast pace. This is dovish for inflation because it lowers monetary velocity.
Unemployment - We're at record low unemployment numbers, which means (a) wages are being pressured upwards, (b) the population is generating lots of money to spend, accelerating monetary velocity, and (b) there's nowhere for the unemployment number to eventually go but up. This is hawkish for inflation and interest rates, and suggests a more ideal time to buy stocks will be during a future recession or period of high unemployment.

One might consider adding the oil price to the metrics, but it's so volatile and so quickly reflected in stock prices that I don't know if oil counts as a leading metric.

There's also an element of strategy here. If 2022 is one of those high-risk years where the odds of big losses are piling up and the potential gains could be modest, then maybe it makes sense to sit this one out with a defensive AA. When the SHTF, we'll know it and be ready to pounce. But if we can detect a possible turning point - signs of inflation peaking for example - then the high-risk narrative is reduced. As I've shown, the market expectation is for rate hikes to end when the Fed reaches their "neutral" rate. So the outcomes could be:

1) Fed fails to raise rates to 2.25%-2.5%.
2) Fed reaches 2.25%-2.5% in early 2023 and parks it there for a while.
3) Fed raises rates beyond 2.5%.

There are 2 ways #1 could happen: either a recession or an unforeseen collapse in inflation in the 2nd half of 2022 that turns the Fed cautious. The Fed has clearly signalled rate hikes are happening no matter what, because of past/current inflation numbers and their belief in a "neutral" rate. However, markets could rally hard if inflation numbers collapse later this year and the timeline for rate hikes is extended*. Several of my preferred metrics point to a good chance of collapsing inflation. That might not be the buy signal it looks like though, because history shows that the Fed often hikes rates amid slowing monetary velocity, causing the recessions that blow up the stock market.
*By extended, maybe we're talking about 6 mos, but from what I've heard from Fed presidents, there's an urgency to get to "neutral" ASAP. A delayed implementation of "neutral" could help the market if at least some investors think it reduces the odds of recession. E.g. If earnings growth can absorb a slow stream of added interest costs, maybe current stock valuations are too low.

#2 is currently priced into the market. Someone long in the stock market might think low unemployment is driving corporate profits upward at a faster pace than the market's valuation suggests. But a 2018-style 20% correction is not out of the question, so maybe hedge and have a criteria to cash in the hedge.

#3 is definitely not a market you want to be long in. This is the high-inflation 1970's repeat scenario. The market disagrees and unemployment is the only metric suggesting this scenario (and we've had full employment coexist with unusually low inflation in recent years). But because this scenario is not priced in, the market's reaction to supporting information could be violent.

So strategically, I see several ways for investors to lose big and one or two lower-probability scenarios for a normal market year. There are always reasons not to invest, as the old chart suggests, but to me the odds of negative scenarios seem almost locked-in due to inevitably rising rates. I'd like to ask everyone how they would tweak this model, what new data sources they'd consider, etc.

[cool7hand]

There's a lot to digest here. Thank you for posting!

[MustacheAndaHalf]

@ChpBstrd - In the CPI-U report I cited, each item is given weight proportional to usage by consumers.  In your list, it's not clear how much impact each item has on inflation, so here are my own guesses:

Government spending The Fed reduced bond buying starting late 2021, and ceased bond buying in March.  The government discussed QT in Dec 2021, which shocked markets on Jan 5th when Dec FOMC minutes came out.  The Fed discussed QT of up to $95B, but until the Fed acts, I think the market ignores government spending.
I lump Money supply with government spending - correct me if that's wrong.
In over 60 years, the Personal Savings Rate never spiked as high as it did during 2020-2021, so we have to treat that as abnormal data caused by Covid-19.  With Omicron people got back to normal, which I think is shown in the local minimum Oct/Nov of 2021.  But look at the Dec/Jan dip from 8.4 to 6.1 ...
https://fred.stlouisfed.org/series/PSAVERT
I speculate this could be very dangerous.  If people talked about higher prices with family in December, and then spent their money more quickly in Jan ... it's a sign of inflation becoming endemic.  If prices go up every month, people eventually realize they need to buy things sooner, before prices go up more.  This added demand is a feedback loop, which pushes prices higher and draws more people in to spending faster.  It's very dangerous, if that is what has begun, but that is speculation on my part.

New higher Inventories signal an end to supply chain problems... but there's some problems.  First, to quote several analysts including Schwab's Liz Ann Sonders, "companies have switched from just in time to just in case".  Holding inventory ties up money that can't be spent on new factories and employees, and China's lockdowns are becoming more significant over time.  I expect these is more disruption here than suspected.

The Yield Curve inversion may signal recession 1-2 years later, so for now I don't expect it to impact bond yields.
In my view the impact of a Trade Deficit is minimal.  Hasn't the U.S. run a large trade deficit for many years?
Although Unemployment is low, wages have gone up less than inflation.  The number is higher (nominal), but the after inflation salary is lower (real).  So wages are not yet pushing inflation up, but could later.

---
I've read that historically inflation subsides once bond yields exceed inflation by about 2%.  So let me assign a number to the collapse of inflation, and say it drops in half.  That means 9% inflation collapses to 4.5%.  But as I understand it, the Fed still needs to push bond yields above 6%, so the Fed funds rate would need to be closer to 5%.  This isn't how the Fed views things - they see a purely supply side problem that was getting better - and then China locked down.

Look at the Fed's record: they claimed supply side problems were transitory, and would end with the pandemic.  Instead inflation climbed to 7%.  The Fed then expected inflation to end in 6 months, and yet after 4 months inflation has risen again to 9%.  I have trouble believing the Fed is both data driven and has only raised rates to 0.25% during 9% inflation (and rising?).

Recently on CNBC, Steve Liesman pointed to a gap between the Fed's projected funds rate (2.25% or 2.5%) by year end, and the market's projected 2.75% rate.  This all driven by the Fed's "soft power", where it drops hints and the market reacts by pricing it in.  If the market stops trusting the Fed, this breaks down.  The Fed would have to actually make the rate hikes, putting it even further behind.  I don't know the chance this happens, but I suspect it's a risk the market analysts aren't even considering.

By the time consumer behavior reacts to inflation, I think drastic measures are required.  A key question based on data: why did consumers spend 1/4th of their savings between Dec and Jan?  In past years savings went up between those months, so normal gift buying isn't the explanation.  If my speculation is right, consumers are changing behavior, which I already described as very dangerous.  Roughly speaking, it's like a bank run on the whole U.S. economy.

One signal I might be wrong is the higher inventories.  But those were building up as consumers were spending more, and companies were desperate for products.  They placed duplicate orders, so they might have overcompensated for consumer behavior.  I'd really need more data to pick through this.

Ultimately I'm investing in inverse bonds for 3 months, and I predict higher inflation over the next 3 months.  I believe the Fed will set expectations for even higher bond yields, and even announce QT has begun.  As bond values drop, I hope to profit off that with inverse bond exposure.

I'm limiting this to 3 months for a couple very weak reasons, some of which I'm probably forgetting.  The Fed has 3 meetings in 3 months, which gives lots of opportunities to change expectations in a shorter period.  According to Investopedia, October is feared for having more crashes than any other month.  While I want short term profits, I'd like to avoid a higher risk month - thus selling after about 3 months.  Apologies for the lack of reasons, but this long post hasn't even reached my discussion of crash risks.
https://www.investopedia.com/articles/financial-theory/09/october-effect.asp

---
Above I set aside my thoughts on a stock market crash.

For a soft landing, the Fed has to carefully destroy demand enough to reduce inflation without triggering recession.  How many European investors will buy higher yielding U.S. Treasuries, while considering the exchange rate risks of a strong dollar?  How will lockdowns in China play out, and how much supply chain disruption results?  If the market doesn't believe China's official numbers, how can the Fed do better?  If German voters push politicians to stick to their word - end buying of Russian oil & gas in 2022, how much inflation results?

The Fed has no chance of correctly predicting every single one of those events, which I think leaves them only one path: a lucky guess.  The Fed can't calculate each event, so it has to make a guess at the total inflation over time.  This makes a really strong case for recession, in my view, highlighted by the Fed already getting inflation wrong for most of 2021.  They predicted inflation would no longer be a problem by July 1 2022... and they didn't even get the direction right, with inflation rising from 7% (Dec) to 9% now.  What are the odds inflation falls to 0% in two months, making the Fed's prediction right?

At the very least, I view the chance of a Fed policy mistake as very high.  Policy mistakes can trigger recession, so I consider recession risks similarly high.  There's also other risks here - I read an article about fears of high inflation and Fed inaction... under President Trump.  The year was 2018, which was one of the rare years where the Fed performed QT (bond selling).  With much more at stake, the Fed has to start QT again, and I think that will be very risky.  So overall I expect a Fed mistake and recession, but I suspect that takes longer than 3 months to unfold - and I can go with inverse bonds for now.

[ChpBstrd]

I lump Money supply with government spending - correct me if that's wrong.

They're relatives, but not twins. The dynamic has been for money supply and government spending to increase by 2%-10% per year, but to oscillate independently of one another. 2020-2021 saw M2 increase 40%, as a large part of the government's budget in those years consisted of stimulus deposits to households.

Critics might call this a devaluation, and say 40% is the amount of excess inflation we should expect to see over the next few years. I don't trust this kind of model because if one extends that logic backwards in time, the predictions for what prices should be today become ridiculous (almost as ridiculous as the various internet claims that the government is faking inflation numbers and it's actually been 10-15%, compounded, for very many years).

A model that better fits the data would say money supply matters to prices, but its effect is attenuated by economic growth. I.e. If the world's dollar economy grows 5%, then the supply of money has to grow 5% too. Otherwise a shortage of dollars and deflation would occur. If we want to engineer a healthy 2-3% rate of inflation, then maybe 5% economic growth needs to be accompanied by a 7-8% increase in money supply. As foreign governments and households increase their savings in USD, even more money supply is needed to keep trade in balance and keep inflation a positive number.

Government spending and deficits are how the US expands the worldwide dollar supply. You could say dollars - the world's most reliable, liquid, and universally accepted currency - are the U.S's main export. Americans have benefited (milked?) their reserve currency status because we don't have to pay enough taxes to balance our budgets and because our interest rates are pressured down by insatiable foreign demand.

This model explains Alan Greenspan's "conundrum" of persistently low inflation amid rapidly growing M2 and the ineffectiveness of interest rate policy in the 2000's. Foreign demand for a reliable currency props up the USD, and the trade deficit represents the flow of dollars out of the price-setting economy (sort of like QT) with a decent number of those dollars never to return to US shores. We have to keep these factors in mind when guessing what will happen to US inflation next, because the factors are still there.

In over 60 years, the Personal Savings Rate never spiked as high as it did during 2020-2021, so we have to treat that as abnormal data caused by Covid-19.  With Omicron people got back to normal, which I think is shown in the local minimum Oct/Nov of 2021.  But look at the Dec/Jan dip from 8.4 to 6.1 ...
https://fred.stlouisfed.org/series/PSAVERT
I speculate this could be very dangerous.  If people talked about higher prices with family in December, and then spent their money more quickly in Jan ... it's a sign of inflation becoming endemic.  If prices go up every month, people eventually realize they need to buy things sooner, before prices go up more.  This added demand is a feedback loop, which pushes prices higher and draws more people in to spending faster.  It's very dangerous, if that is what has begun, but that is speculation on my part.

I drew a different conclusion, which requires less coordinated thinking power on the part of consumers. People's savings rates went up because mall shopping and restaurant dining were not the wisest things to do in the middle of a deadly respiratory virus pandemic, and because they were simultaneously having stimulus checks deposited into their accounts. As the fears abated, people had all this money saved up burning a hole in their pockets. From mid-2021 until now people have been blowing through this windfall, and the falling savings rate reflects that behavior.

Economists talk about expectations and about people pulling their spending forward to avoid price hikes, but I question people's economic foresight when 56% of Americans could not cover an unforeseen $1,000 expense. For most people, money in hand is money soon spent. With that little slack in one's budget, exactly how much spending could a person pull forward even if they wanted to? Not much in my estimation.

What we do know is this: Today's low personal savings rate means consumers don't have as much dry powder as they did in mid-2021. If anything, the savings rate is lower than in 2018 or 2019 because people are continuing to spend like it's Black Friday even though the stimulus checks have stopped, and they will soon run out of money. There will not be a repeat of the demand splurge of late 2021 / early 2022 because stimulus money is heading overseas in the form of trade deficits and into the accounts of businesses and shareholders in the form of buybacks and dividends. The personal savings rate statistic tells me consumers have just about spent their entire windfalls.

I've read that historically inflation subsides once bond yields exceed inflation by about 2%.  So let me assign a number to the collapse of inflation, and say it drops in half.  That means 9% inflation collapses to 4.5%.  But as I understand it, the Fed still needs to push bond yields above 6%, so the Fed funds rate would need to be closer to 5%.  This isn't how the Fed views things - they see a purely supply side problem that was getting better - and then China locked down.

Yea, that's the scary historical parallel that nobody wants to think about right now. 5%-6% yields are definitely NOT priced into bonds or stock valuations, and that outcome would imply a S&P500 PE ratio in the upper teens (15-19ish), as happened in the mid-1990s and early-1970s when rates were last in that range.

If this is our model, we should short the market right now. However, the thing that didn't exist in historical times is QT. Today's Fed could potentially do a lot of the work of slowing monetary velocity with asset sales instead of interest rates, whereas in the past they relied almost exclusively on interest rates.

I failed to anticipate or understand why the Fed maintained QE for too long in 2021-2022 when it was clearly not needed, and then failed to understand why QT wasn't their first instinct rather than raising interest rates. Instead, it looks like the Fed considers interest rates to be their primary tool, and they might raise rates 1% before they even start QT. They're focusing on raising the short duration end of the curve and utterly ignoring the long end. It's not the way I would have done things, but I can't let wishful thinking stand in the way of reality. The fact is, they're taking a very traditional approach.

Look at the Fed's record: they claimed supply side problems were transitory, and would end with the pandemic.  Instead inflation climbed to 7%.  The Fed then expected inflation to end in 6 months, and yet after 4 months inflation has risen again to 9%.  I have trouble believing the Fed is both data driven and has only raised rates to 0.25% during 9% inflation (and rising?).

It's an ad hominem fallacy to say that because the Fed was wrong in the past, they will be wrong again in the future, unless we can point to some systematic flaw in their structure, process, or mission that we propose causes the wrongness to occur, and will continue to cause it. So I would amend the statement above to say "The Fed's process involves not changing direction until many months' of data support a change in direction. Therefore, the Fed will continue to under/over estimate inflation until several months of data have been received."

As an example of why being wrong in the past is irrelevant to future statements, consider how wrong the US intelligence community was about weapons of mass destruction in Iraq, and how many people discounted the US intelligence community this year when they warned for two months that a Russian invasion of Ukraine was highly probable, and then imminent. The French didn't believe them. Not even the president of Ukraine believed them, but this prediction turned out to be 100% correct. The lesson is that people and entities can go from being consistently wrong on one subject to absolutely right on another.

One signal I might be wrong is the higher inventories.  But those were building up as consumers were spending more, and companies were desperate for products.  They placed duplicate orders, so they might have overcompensated for consumer behavior.  I'd really need more data to pick through this.

It definitely means less pricing power for wholesalers and retailers when the shelves are all stocked and consumers are no longer blowing their stimmie checks at Wal Mart.

Ultimately I'm investing in inverse bonds for 3 months, and I predict higher inflation over the next 3 months.  I believe the Fed will set expectations for even higher bond yields, and even announce QT has begun.  As bond values drop, I hope to profit off that with inverse bond exposure.
...

For a soft landing, the Fed has to carefully destroy demand enough to reduce inflation without triggering recession.  How many European investors will buy higher yielding U.S. Treasuries, while considering the exchange rate risks of a strong dollar?  How will lockdowns in China play out, and how much supply chain disruption results?  If the market doesn't believe China's official numbers, how can the Fed do better?  If German voters push politicians to stick to their word - end buying of Russian oil & gas in 2022, how much inflation results?

The Fed has no chance of correctly predicting every single one of those events, which I think leaves them only one path: a lucky guess.  The Fed can't calculate each event, so it has to make a guess at the total inflation over time.  This makes a really strong case for recession, in my view, highlighted by the Fed already getting inflation wrong for most of 2021.  They predicted inflation would no longer be a problem by July 1 2022... and they didn't even get the direction right, with inflation rising from 7% (Dec) to 9% now.  What are the odds inflation falls to 0% in two months, making the Fed's prediction right?

At the very least, I view the chance of a Fed policy mistake as very high.  Policy mistakes can trigger recession, so I consider recession risks similarly high.  There's also other risks here - I read an article about fears of high inflation and Fed inaction... under President Trump.  The year was 2018, which was one of the rare years where the Fed performed QT (bond selling).  With much more at stake, the Fed has to start QT again, and I think that will be very risky.  So overall I expect a Fed mistake and recession, but I suspect that takes longer than 3 months to unfold - and I can go with inverse bonds for now.

I agree. The Fed has a very narrow window of good outcomes that fall between causing a recession and allowing inflationary expectations to set in. The odds of nailing the landing seem slim.

The Fed has commented in recent years about letting inflation deviate from the target for longer periods of time. They want to be less reactive, and to stop swerving policy back and forth so often, as they did in 2018-19. They seem to want to be behind the curve, where the trends are more clear and action more justifiable. Perhaps they are only responding - slowly - to 9-12 month trends from now on. And maybe that's how we ended up with 8.5% inflation before the Fed even cancelled QE, and with a March 2022 rate hike of only 0.25% in response!

Will the Fed stick with strategic slowness amid an environment of uncomfortably high inflation, commodities shortages, and full employment? Or will the "act now!" camp win the day with 0.5% rate hikes for all the remaining meetings of 2022? The comments about letting inflation "run hot" came before the infamous "transitory" comments, but you don't hear much of either now. Anxiety about being recorded in history as being too slow to respond to what became the inflationary cycle of the 20's probably haunts Fed presidents. As 2020 proved, they are not unwilling to turn on a dime.

The Fed seems to be highly decisive and effective at bailing the economy out of emergencies, but they tend to make type 1 errors and over-react to the regular business cycle. Their newfound strategic slowness may be an attempt to reduce this tendency. Will they go into emergency mode this summer or continue to manage at the level of multi-year trends? Like I said, I think we'll know by June or July. If inflation doesn't peak by then, expect an emergency response.

Inverse bond funds seem like a good bet if you believe rates are going above the Fed's neutral rate that is currently priced into the market. What would have to happen for this bet to lose? One losing scenario would be increased odds, in the market's estimation, of a more-abrupt-than-expected recession or financial crisis this year. Rising recession risks would persuade investors to expect a cessation of rate hikes, maybe at a peak of 1.5%-2%. This would cause bonds to appreciate because they are currently discounted for a 2.25%-2.5% Fed Funds Rate. Inflation could collapse at the same pace as it rose in 2021 and we'd be back to 1% inflation expectations by 2023.

I don't necessarily think this is likely; I'm just spelling out the scenario that would cause this strategy to lose, as one should always do. Another way to think about this bet: Consumer demand in 2022 will be lower than in 2021 if the effects of lower unemployment are less than the effects of going from $4T stimulus to nothing.

Ironically, the Chinese COVID situation feeds this loop. If their economy goes into recession, it's going to take a lot of the world along with it (China is the world's largest economy). At the same time, reduced demand for US treasuries from Chinese producers would contribute to higher long-duration rates, though this would be offset by lower US government spending constraining the supply of treasuries. Throw in some policy mistakes and a slowdown in demand from US consumers, and then it seems a deep Chinese recession could come next, which would further curtail demand for treasuries.  This would be the stagflation scenario's feedback loop, and it could be made even worse if the Fed keeps raising rates into the recession, in response to irrelevant inflation data from 12 months ago.

Maybe in addition to your short bonds idea, we should be considering long strangles or straddles on the Nasdaq, tech stocks, mREITs, or Chinese stock funds, if volatility gets low enough of course. This would be a bet that the market is wrong about the soft landing scenario, with an awareness that "transitory" inflation could still occur on a longer timeframe than expected and that the Fed won't necessarily overreact this time.

[blue_green_sparks]

My ideal scenario would be to grab some 4 or 5% fixed just before inflation tanks back down to ~2% as the stock market starts to take off and we trade our I-bonds for stocks. It could happen, LOL.

[ChpBstrd]

Maybe it's just a series of short-term chart zig-zags, but several commodities seem to have peaked in price and are heading back down.

Crude oil: Down 15.8% since 3/8 peak: https://tradingeconomics.com/commodity/crude-oil

Copper: now lower than a year ago, suggesting reduced construction demand? https://tradingeconomics.com/commodity/copper

Lithium: peaked in late March, now curving down: https://tradingeconomics.com/commodity/lithium

Natural Gas: Peaked on 4/18, up today but no longer near that peak: https://tradingeconomics.com/commodity/natural-gas

Gold: Down 7.13% since the 3/8 peak: https://tradingeconomics.com/commodity/gold

Lumber: Down 3% since early March: https://tradingeconomics.com/commodity/lumber

Wheat: Down 13.8% since 3/8 high: https://tradingeconomics.com/commodity/wheat

There are exceptions, as always. Things like soybeans, milk, and steel are still in upswings. Coal and the Baltic Dry Index peaked, fell dramatically, and is now in a small upswing. Still, there's a case to be made that the biggest producer price inputs are on their way down, and if they keep falling, or if other commodities join the trend, it will eventually pull down inflationary expectations. The CRB index is down 6.1% since the 4/18 peak, and the LME is down over 12% since it's 3/7 peak.

[MustacheAndaHalf]

@ChpBstrd - In the mere days since I posted, crash risks have gone way up.  I can't stay in inverse bonds in that environment, so I've sold.  Regardless of what I think of the supply side, if demand collapses so does inflation.  What you're seeing in commodities is likely China being at risk of locking down Beijing, and lowering it's growth estimates further.  The losses in the U.S. markets may also be a factor.

Let me quote you so I don't misinterpret:

... an ad hominem fallacy to say that because the Fed was wrong in the past, they will be wrong again in the future

I'm making an ad hominem attack on Jay Powell and his behavior over 1 year.  Fed Chair Powell called inflation "transitory" from early 2021 to late 2021.  He dropped "transitory" because he was wrong.  The Fed "dot plot" represents the full 12 members of the Fed, and at the end of 2021 it showed 2 expected rate hikes, or 0.50% worth.  That is a nonsensical response to 7% inflation, and they soon went to 3 hikes... 4... 5... in other words, continously wrong.  And that is my claim: the Fed has been continously wrong on inflation for the past 12 months.

I was far from alone in mocking the Fed for calling inflation "transitory" for most of last year.  In a "jump the shark" move, now the Fed seems to be contradicting textbook economics and claiming higher treasury yields will not hurt employment.  This time, the market is mocking the Fed as being in "la la land", or believing in "immaculate tightening".  A Fed that gets mocked each year is a pretty good choice for ad hominem attacks!

But as I mentioned, I've switched to investing for the crash.  Earlier I expected to wait 3 months - but now see markets falling quickly, and possibly crashing.  In that environment, I can't hold inverse bonds, and have flipped to holding their opposite: long-term bonds.  That's another reason not to imitate my approach: by the time someone starts buying per my post, they could be buying from me as I start selling.

[ChpBstrd]

I agree the Fed ignored a lot of information for a long time in 2021, and I have my own ideas of what they should have done (abruptly reverse QE last fall for example). But the reason I pointed out the logical fallacy is because the Fed’s past failures are being used to make a claim about whether they will error in the future. In formal logic, the previous error does not directly support the claim of the present error. A long string of errors, or evidence that errors are more common than successes, can be used as evidence for inductive logic, but generally “they were wrong in the past” is used as a discrediting rhetorical tactic.

With so much at stake, it is critical that we draw sharp lines around what we DON’T know.Overconfidence kills! We don’t see all the evidence the Fed sees, nor do we understand their mysterious decision process. We can only guess about the journal articles they read, the macro trends they fear, the biases they carry, or the politics they deal with. I admit that I don’t understand the value they place on gradualism, or why they don’t use QE/QT as a fine tuning tool instead of an emergency sledgehammer. Last year I thought I knew something about what they’d do because it made sense from my perspective, and I was flat out wrong.

To illustrate, suppose the Fed presidents all agree that their task is theoretically futile because of the chaotic systems in the economy. Thus, accommodative or restrictive policy is secretly made by quarterly coin flips, because that’s their historically best performing method. It came up heads last time, and in hindsight that was the wrong answer.In five more flips, the wrong thing to do keeps coming up. What are the odds of them picking the right answer this time? It’s still 50% because the coin flips are independent.

If we are persuaded by discrediting rhetoric, we might bet everything that the next decision will be an error. We would, in fact, have fooled ourselves into a bet with 50/50 odds.

[MustacheAndaHalf]

To illustrate, suppose the Fed presidents all agree that their task is theoretically futile because of the chaotic systems in the economy. Thus, accommodative or restrictive policy is secretly made by quarterly coin flips, because that’s their historically best performing method. It came up heads last time, and in hindsight that was the wrong answer.In five more flips, the wrong thing to do keeps coming up. What are the odds of them picking the right answer this time? It’s still 50% because the coin flips are independent.

If we are persuaded by discrediting rhetoric, we might bet everything that the next decision will be an error. We would, in fact, have fooled ourselves into a bet with 50/50 odds.

Back in Oct 2021, one rate hike was expected, as I mentioned above.  That increased to 2 in Dec and 3 in early Jan.  The market adjusted expectations based on the Dec Fed meeting, and then again when minutes of that meeting came out.  If you look at the Fed and market reactions, you can see this dynamic.

Proposing a coin flip theory ignores the dynamic, and has almost no chance of working rather than the 50/50 you assume.  Markets expect 2.75% of rate hikes from the Fed because of numerous statements and dot plots of the Fed.  But start flipping coins, and nobody can trust Fed guidance.  Markets are certain that the Fed will raise rates 0.50% this week.

If the Fed makes no rate hikes this week, because of a coin flip, that wipes out all the work they've done to guide markets.  The markets were certain of an event, and the Fed did not do what it said.  Lying by the Fed would cause bond yields to fall dramatically as all prior guidance was proven to be a lie as well.

Right now the market has priced in 2.75% of rate hikes, and the Fed has delivered 0.75% (as of tomorrow, 0.25% now).  If the market can't trust the coin-flipping Fed, then bond yields need to crash near 1%, representing what the Fed has done rather than what it expects.  So instead of having 3% yields in 9% inflation, the Fed suddenly has 1% yields in 9% inflation.

Instead of being behind, the Fed becomes hopelessly behind - all in one surprise coin flip.  No, a coin flip does not have a 50/50 chance of working, but has a near certain chance of breaking trust in the Fed, and forcing the Fed to deliver on each rate hike instead of the market pricing them in.

[ChpBstrd]

Here's an interesting perspective from Andrew Levin, former Fed staffer. He says the "neutral" rate could be seen as some amount slightly greater than the current rate of inflation.

https://www.marketwatch.com/story/powell-wants-to-get-closer-to-neutral-but-whats-that-think-between-5-and-6-former-top-fed-staffer-says-11651566417?mod=home-page

The story links to a Federal Reserve Board webpage that spells out this principle that stimulus/restriction is a matter of real interest rates, which uses an estimated "neutral" rate as an input:

A third principle is that the central bank should raise the policy interest rate, over time, by more than one-for-one in response to a persistent increase in inflation and lower the policy rate more than one-for-one in response to a persistent decrease in inflation. For example, if the inflation rate rises from 2 percent to 3 percent and the increase is not caused by temporary factors, the central bank should raise the policy rate by more than one percentage point. Such an adjustment to the policy rate translates into an increase in the real policy rate--that is, the level of the policy rate adjusted for inflation--when inflation rises and a decrease in the real policy rate when inflation slows.

That helpful site goes on to explain the Taylor Rule and its derivatives for modeling economic policy.

Levin's warning is that this means rates could go much, much higher than markets currently expect. Perhaps the Federal Reserve Board wants to give the current inflation wave more time to crest before jacking the Federal Funds Rate beyond the rate of inflation at a fast pace, and they're willing to tolerate all the "behind the curve" criticism until they actually find the backside of the curve. But at this point, even if they're looking at a trailing year's worth of data, inflation's long-term trend is above target. So they have a green light to hike very aggressively, according to their own published method.

Then again, it appears the gradualistic inertial rule and first-difference rule more closely predict actual Fed policy than the earlier models. Recent comments by Fed presidents about a neutral rate of inflation imply they are looking hard at the inertial rule.

James Bullard last month illustrated how the Talor Rule with the most conservative inputs possible (E.g. PCE instead of PCI) recommends a 3.5% FFR.

https://www.stlouisfed.org/-/media/project/frbstl/stlouisfed/files/pdfs/bullard/remarks/2022/apr/bullard-mizzou-07-apr-2022.pdf

That's much higher than the 2.25%-2.5% I was expecting, and would imply the S&P500's PE ratio should be in the mid-to-high teens rather than 21 where it sits today. However, the Taylor model Bullard illustrates is also the most volatile of all the Fed's models, and has not been predictive in the past. If inflation nosedives this summer/fall, the Taylor model's indications will nosedive faster than rate hikes can get to its old prescriptive rate.

My baseline expectation is still that peak inflation occurs in 2H 2022 and steadily declines from there. This will be due to the sudden withdraw of stimulus, minus some months of lag time, as compared to our 2021 reference period. I'm also expecting a minor, and weird, full-employment recession sometime in 2022 for the same reason; it's just very hard to beat the economic growth and consumer spending of the stimulus era, and especially as rising prices are crimping consumer spending. However, IDK how far the Fed might try to overshoot inflation, or if they quit raising rates in response to a recession before things ever get too high. The risk is awfully high when our upside to interest rate risk is literally a recession scenario.

[EverythingisNew]

There is a lot of good data and forecasting here! Thank you @ChpBstrd

The more I observe the US stock market, the more I think that the Fed ultimately controls the direction more than any other factor. “Don’t fight the Fed” they say when the stocks go up.. Can’t the inverse be true as well? When rates go up, the stock market will go down because the US economy is built on credit more than anything else! I think this theory is so reliable that you could time the market by buying when rates drop and selling when they rise. When the Fed raises the rates, the best economists are looking at the most comprehensive data and actively trying to cool the economy. They are trying to lower spending and lower company profits. Don’t fight the Fed.

[ChpBstrd]

I originally proposed three possible outcomes.

     a) Severe Recession Scenario: a massive disinflationary recession within the next couple of years that will cause the 5-year average inflation to fall to 3.4% despite today's 8%+ inflation readings (e.g. 3.4% = AVERAGE(8%,0%,3%,3%,3%), OR...

     b) Transitory Scenario: a rapid collapse in inflation - the "transitory" narrative but on a longer time scale than people were thinking last year. This would be because we went from $4T+ stimulus and QE in the last couple of years to zero all of a sudden in 2022, with rising interest rates too, and about a year of lag time (e.g. 3.4%=AVERAGE(8%,2.2%,2.2%,2.2%,2.2%). This would be the "soft landing" scenario in which monetary velocity returns to the existing trendline. OR...

     c) Fed Overreaction, a scenario in which inflation collapses for its own reasons at the same time as the Fed tightens policy and we're close to recession/deflation again in 12-24 months. In this scenario, the Fed has a delayed overreaction to what would have been transitory inflation. They ignore the short-term causes (stimulus legislation, commodity shortages) and tighten money supply just as the economy is slowing anyway. Recession occurs and rate hikes are stopped at about the level the bond market is predicting.

Next we need to build a logic model to illustrate the investment outcomes of these various scenarios, and the signals that would increase the odds of each scenario.

a) Severe Recession
     i) Signals:
          -sudden reversal in commodities index
          -sudden increase in inventories
          -sustained yield curve inversion: 10/2s or 10/3mo
          -rapid fall in inflation, accompanied by continued Fed rate hikes OR...
          -continued increases in inflation into the 7-10% range.
          -asset price meltdowns (housing and mortgages, growth stocks, financial institutions)
     ii) Most likely outcome:
          -25-30% drop in S&P 500 from here (not unusual in recessions) within the next 2y.
               *A S&P500 P/E ratio in the mid-teens is historically fair for environments where 10y treasuries yield 3.5%.
               *The earnings yield (E/P) is currently (1/21=) 4.76% which is not high enough if treasuries are heading to >4%!
               *Market over-reactions during recessions can push valuations far lower than a "fair" equity risk premium suggests.
               *Buy signal: S&P500 ttm PE ratio hits 15-17.
               *In the height of the panic, safer assets such as preferred stocks can yield 7.5%+.
                    -This could represent a retirement lock-in opportunity at >4% WRs, as it was in 2020.
          -bonds may drop until the recession is widely expected, at which point they could rally.
     iii) Winning strategy
          -stay in cash until you can pick up preferreds and corporate bonds at yields equaling WR + a modest inflation estimate.
          -pivot into a stock-heavy portfolio at a point of very high pessimism.
     iv) Historical parallel
          -1999-2003
          -2004-2007

b) Transitory Scenario
     i) Signals:
          a) metrics mentioned above show steady economic growth despite rate hikes
          b) a healthy yield curve
          c) a mild technical recession could still occur, but against 2021 comps this isn't necessarily a bad sign.
               -consider how much the $1.9T stimulus contributed to GDP in 2021. 2022 can't match that.
          d) inflation slowly falls in summer/fall 2022 in response to higher rates and QT.
      ii) Most likely outcome:
           a) 1-10% growth for the S&P500.
           b) modest bond losses
      iii) Winning strategy:
           a) Buy and hold a stock-heavy portfolio or rebalance through the volatility.
      iv) Historical parallels:
           a) 2018
           b) 2012-2013
           c) 1993-1994

c) Fed Overreaction
     i) Signals:
          a) Fed minutes utterly discount the possibility of falling inflation and employment
          b) Fed minutes suggest the inverse of "letting inflation run hot for a while" as they said in 2020.
          c) Continued rate hikes through late 2022 despite inflation falling to the 2-4% range or lower.
          d) Escalating rate hike expectations... 4%... 5%... 6%...7%!
     ii) Most likely outcome:
          a) Rate hikes drive the 10y yield to 5-6% even as inflation falls.
          b) S&P500 PE ratio goes into the low teens. 30%+ correction.
     iii) Winning strategy:
          a) Sit in cash or hedged positions for at least a year, maybe up to 2.
          b) Buy when S&P500 valuations are about a third lower than they are currently.
     iv) Historical parallel:
          a) arguably most recessions for the past several decades:

[ChpBstrd]

The next round of U.S. CPI numbers and revisions will be released Wednesday. I'm keenly watching whatever indicators I can find because I think once investors sense a downward trend in inflation, they will call a bottom and plow into stocks. On the other hand, a negative revision and unexpectedly high number could result in more losses for those holding stocks/bonds.

Evidence in favor of lower inflation:

The PCE excluding food and energy metric may have already peaked, going from 5.3% in Feb. to 5.2% in March.
https://www.bea.gov/news/2022/personal-income-and-outlays-march-2022

Used car prices may be heading back down:
https://publish.manheim.com/content/dam/consulting/ManheimUsedVehicleValueIndex-LineGraph.png
https://fred.stlouisfed.org/series/CUSR0000SETA02

Shipping logistics are improving, as ocean freight reliability is increasing.
https://www.sea-intelligence.com/press-room/137-schedule-reliability-improves-again-in-march-2022

The price of gold has been tanking since mid-April - exactly what you'd expect to see if investors are expecting falling inflation.
https://tradingeconomics.com/commodity/gold

Consumers' inflation expectations fell in April, well below forecasts.
https://tradingeconomics.com/united-states/inflation-expectations

The London Metals Exchange (LME) Index continues to fall from peaks reached in early March.
https://tradingeconomics.com/commodity/lme

Evidence in favor of higher inflation:

Oil prices are still in an uptrend, and gasoline is rising even faster.
https://tradingeconomics.com/commodity/brent-crude-oil
https://tradingeconomics.com/commodity/gasoline

Coal and natural gas have risen, despite a little down trend last week for N.G.
https://tradingeconomics.com/commodity/coal
https://tradingeconomics.com/commodity/natural-gas

Most food commodities like wheat, soybeans, rice, corn, milk, and orange juice are higher than they were a month ago, although a couple of these are in a down trend within the past couple of weeks.
https://tradingeconomics.com/commodity/wheat

The diversified GSCI Commodity and CRB Indexes are still climbing.
https://tradingeconomics.com/commodity/gsci
https://tradingeconomics.com/commodity/crb

This inflation episode is being driven by food, energy, and consumer goods. That's why the LME is falling while the diversified indices are rising. Yardeni pegs the CPI as growing only 4% if energy and food are removed, and the food, energy, and consumer goods sectors are far ahead of healthcare, tuition, lodging away from home, durable goods, etc.
https://www.yardeni.com/pub/cpicomp.pdf

This explains the narrative that China's lock-downs and the Ukraine war are driving inflation. Neither of these factors is likely to have changed during April in a way that increases supply. The improved logistics situation could just be an artifact of reduced Chinese production and/or the start of a decline in consumer spending.

Next it's worthwhile to consider that commodity prices may reflect speculation more than supply and demand. That may be a relevant concern when trying to predict prices in July/August, but we already have prices for what happened in April. In trying to guess the April numbers, I don't think the mix of commodity prices that are falling (e.g. metals) will reduce the overall indexes or meaningfully impact the April numbers. Therefore I'm not expecting a particularly good CPI number.

To make things worse, CPI growth hit an anomalous flat spot between March 2021 and April 2021, so the gap between April 2021 and April 2022, against a steady trend, could be made larger by the big comp against a dip in the trendline. The CPI growth rate actually fell between June and August 2021 (i.e. the false dawn that led to the "transitory" label), so even if the trendline is constant, the CPI-boosting factor from that flat spot will be with us until the September 2022 CPI is published. https://fred.stlouisfed.org/series/CPIAUCSL

Inflation might not start to cool down until August or September, but that's three to four 0.5% rate hikes away, and the Fed is likely to keep increasing in quarter-point increments even on the downslope. Interestingly, the Fed's own dot plot predicts rates a lot lower than the market predicts, suggesting either the expectation of recession or a residual commitment to the dovish "transitory" narrative. Who to believe? The market or the Fed? Suffice to say I won't be making any big bullish bets this week.
https://www.chathamfinancial.com/technology/us-forward-curves

[Mrs. Burning Bush]

This is a really interesting thread ChpBstrd.  Thanks for starting it and updating it!  I don''t have any predictions as to whether or not inflation will be a lasting problem, but we certainly see its effects where we live.  And we have tried to incorporate some hedges against inflation into our asset base - but there don't seem to be a lot of good options.

[ChpBstrd]

A very interesting read. Thanks, ChpBstrd!

I doubt this changes your prediction or analysis, but I have one issue with the "demographic graying" factor you mentioned (and I've seen mentioned elsewhere on the Internet).

If you look at the US population structure (https://upload.wikimedia.org/wikipedia/commons/3/32/USA2020dec1.png), right now the biggest bulge is around 32 years old. If "spending by age" patterns hold (see BLS: https://www.bls.gov/opub/btn/volume-4/consumer-expenditures-vary-by-age.htm), then this largest (living) cohort is currently entering their prime spending years (for roughly the next 2 decades).

Also, just because I was curious, I looked at Japan's population structure in 1995, and it was much different (and more concerning) than the (2020) US one I linked above (Japan had a lot more middle-aged people and a lot fewer children, relative to the entire population): https://upload.wikimedia.org/wikipedia/commons/7/7f/Japan_sex_by_age_1995.png

Demographic graying is definitely going to be a trend in a lot of countries, but I don't think the US is going to look like Japan.

I know this post is more about forecasting the next few months to year, but I wanted to dig into this question further. The dependency ratio is defined as "the ratio of older dependents (people older than 64) to the working-age population (those ages 15-64)".

US dependency ratio: 25.6
https://fred.stlouisfed.org/series/SPPOPDPNDOLUSA

Japan's dependency ratio: 48 (was 25.78 in 2001)
https://fred.stlouisfed.org/series/SPPOPDPNDOLJPN

China's dependency ratio: 17
https://fred.stlouisfed.org/series/SPPOPDPNDOLCHN

So according to the numbers, the US is not where Japan was in the early-to-mid 1990s, it's where Japan was as recently as 2001! Correction accepted, but because graying is a bigger factor than I originally thought. The population graphs you shared earlier are helpful though, because they reveal that the US's trajectory toward Japanification is not as steep as Japan's was. The US hasn't gone on a baby-making strike like Japan has.

The media reporting about demographic graying in China is apparently flat wrong - for now.

I also looked at labor force participation rates for the US vs. Japan. The current US rate of 62% is also about where Japan was in 2001.
https://fred.stlouisfed.org/series/CIVPART
https://fred.stlouisfed.org/series/JPNLFPRNA

In terms of inflation, this supports the bond market's expectation for low long-term inflation rates in the U.S. Even if we aren't in a full demographic collapse like Japan, we are in a slower version of it. An awareness of this big picture, and memories of past overreactions, may be why the Fed has a pervasive dovish tilt even amid 7%+ inflation.

[less4success]

For completeness, here's the same chart for China (all from Wikipedia): https://upload.wikimedia.org/wikipedia/commons/5/55/China_population_sex_by_age_on_Nov%2C_1st%2C_2020.png

[ChpBstrd]

In trying to guess the April numbers, I don't think the mix of commodity prices that are falling (e.g. metals) will reduce the overall indexes or meaningfully impact the April numbers. Therefore I'm not expecting a particularly good CPI number.

Actually I think the April CPI numbers came out pretty good, and supplied evidence in support of the "transitory" narrative.

Overall CPI growth fell from 8.56% to 8.22% between March and April.
https://fred.stlouisfed.org/series/CPIAUCSL#0

However, core CPI was up 0.57% on a month-to-month basis between March and April, running at 6.13% YoY.
https://fred.stlouisfed.org/series/CPILFESL#0

Meanwhile, hourly wage growth also slowed down, going from 5.62% in March to 5.46 in April%. These numbers were released Friday:
https://fred.stlouisfed.org/series/CES0500000003

Together, these charts look a lot like the peak of a hill, to be followed by a symmetrical decline. I'm revising my estimate and now I think there is about a 60% chance March 2022 was the peak of inflation for the next 2 years.

That does NOT mean any of the following:
     -a recession is not occurring now or will not occur in the near future
     -the Fed won't aggressively raise the federal funds rate to 2.5% or more by end-of-year.
     -stocks are a bargain with the S&P500's PE ratio at 20.4 in an environment of 3% treasury rates (going to 4%).
     -a housing crash, mortgage REIT collapse, or bond losses won't cause another financial crisis
     -oil prices won't go even higher

Another interpretation of the falling inflation and wage growth rates is that we're currently in a recession. If and when the market realizes this, expect much wider credit spreads (e.g. rising junk bond yields) and for stocks to start falling due to lower earnings estimates rather than higher discount rates.

Outside of my 401k, I'm mostly in cash but I'm also making small gambles with covered calls on SQQQ, short puts on USO and SQQQ, a long position in Australian rare-earths producer Lynas, and a covered call on nursing home REIT OHI. I also recently won a bear spread on GME and lost a bear spread on BABA. I've beat the S&P500 on a three-month basis, which isn't saying much, but I'm far behind on a six-month basis because I got wiped out holding leveraged long positions in January. Doh!

[PDXTabs]

In trying to guess the April numbers, I don't think the mix of commodity prices that are falling (e.g. metals) will reduce the overall indexes or meaningfully impact the April numbers. Therefore I'm not expecting a particularly good CPI number.

Actually I think the April CPI numbers came out pretty good, and supplied evidence in support of the "transitory" narrative.

Overall CPI growth fell from 8.56% to 8.22% between March and April.
https://fred.stlouisfed.org/series/CPIAUCSL#0

However, core CPI was up 0.57% on a month-to-month basis between March and April, running at 6.13% YoY.
https://fred.stlouisfed.org/series/CPILFESL#0

How do you interpret that? Because I interpret that as "core CPI is up, which is bad." Bad here meaning that the Fed is going to continue to raise rates at 0.5% per meeting until it comes down and I have a house to sell. If it wasn't for my upcoming home sale I wouldn't give a shit.

[ChpBstrd]

In trying to guess the April numbers, I don't think the mix of commodity prices that are falling (e.g. metals) will reduce the overall indexes or meaningfully impact the April numbers. Therefore I'm not expecting a particularly good CPI number.

Actually I think the April CPI numbers came out pretty good, and supplied evidence in support of the "transitory" narrative.

Overall CPI growth fell from 8.56% to 8.22% between March and April.
https://fred.stlouisfed.org/series/CPIAUCSL#0

However, core CPI was up 0.57% on a month-to-month basis between March and April, running at 6.13% YoY.
https://fred.stlouisfed.org/series/CPILFESL#0

How do you interpret that? Because I interpret that as "core CPI is up, which is bad." Bad here meaning that the Fed is going to continue to raise rates at 0.5% per meeting until it comes down and I have a house to sell. If it wasn't for my upcoming home sale I wouldn't give a shit.

The (often revised) core CPI came in higher on a month-to-month basis, but if you edit the chart to show percent change over a year, you'll see the growth curve starting to pivot downward. This might just be an artifact of April 2021 being an acceleration point, and maybe I'm fishing for optimism, but it's the wider trend.

More importantly, reports indicate that things like new vehicles, air fares, and shelter contributed the most to core CPI. If people are scrambling for new cars and plane tickets, that does not scare me as much as if oil prices were going to the moon. Interest rate hikes will take care of the shelter component in time.

[MustacheAndaHalf]

In trying to guess the April numbers, I don't think the mix of commodity prices that are falling (e.g. metals) will reduce the overall indexes or meaningfully impact the April numbers. Therefore I'm not expecting a particularly good CPI number.

Actually I think the April CPI numbers came out pretty good, and supplied evidence in support of the "transitory" narrative.

Overall CPI growth fell from 8.56% to 8.22% between March and April.
https://fred.stlouisfed.org/series/CPIAUCSL#0

However, core CPI was up 0.57% on a month-to-month basis between March and April, running at 6.13% YoY.
https://fred.stlouisfed.org/series/CPILFESL#0

Meanwhile, hourly wage growth also slowed down, going from 5.62% in March to 5.46 in April%. These numbers were released Friday:
https://fred.stlouisfed.org/series/CES0500000003

Together, these charts look a lot like the peak of a hill, to be followed by a symmetrical decline. I'm revising my estimate and now I think there is about a 60% chance March 2022 was the peak of inflation for the next 2 years.

That does NOT mean any of the following:
     -a recession is not occurring now or will not occur in the near future
     -the Fed won't aggressively raise the federal funds rate to 2.5% or more by end-of-year.
     -stocks are a bargain with the S&P500's PE ratio at 20.4 in an environment of 3% treasury rates (going to 4%).
     -a housing crash, mortgage REIT collapse, or bond losses won't cause another financial crisis
     -oil prices won't go even higher

Another interpretation of the falling inflation and wage growth rates is that we're currently in a recession. If and when the market realizes this, expect much wider credit spreads (e.g. rising junk bond yields) and for stocks to start falling due to lower earnings estimates rather than higher discount rates.

Outside of my 401k, I'm mostly in cash but I'm also making small gambles with covered calls on SQQQ, short puts on USO and SQQQ, a long position in Australian rare-earths producer Lynas, and a covered call on nursing home REIT OHI. I also recently won a bear spread on GME and lost a bear spread on BABA. I've beat the S&P500 on a three-month basis, which isn't saying much, but I'm far behind on a six-month basis because I got wiped out holding leveraged long positions in January. Doh!

I guess we had similar ideas with different timings: I sold leveraged S&P 500 and QQQ positions on Jan 5th, which worked out fine.

The market & Fed require much lower inflation to have their views confirmed, and this inflation data is ambiguous.  If you exclude the categories with the most obvious inflation:
"All items less food, shelter, energy, and used cars and trucks"  5.8%

That matches the 5.46% wage inflation and 5.48% average for 30 year mortgages (bankrate).  If inflation has a 5.5% floor, both markets and Fed are wrong, and more rate hikes are needed.  If inflation falls below 5%, then my "status quo" thesis is wrong.  Nearly every analyst agrees the Fed acted too slowly, which is not controversial.  But the idea the Fed keeps acting slowly might be - I see it as a direct result of telegraphing moves and being "data driven", which I expect to continue.

Currently the Fed expects to have a 3.25% funds rate sometime in 2023, although Wells Fargo's Mike Shumacher feels they need another 50 bps added in.  He points to inflation being stickier than expected, which is the case I'm making  (and investing in) as well.

[ChpBstrd]

@MustacheAndaHalf I like your breakdown of inflation into a ~5.5% "floor" where things with temporary shortages make up the difference in CPI. It's a rebuttal to claims that inflation is a factor of one-time events, even if costs for things like fuel have a way of affecting other things. CPI has been at or above 5% since November when we were talking about port congestion and inventory shortages that have resolved since then. Are we just moving from narrative to narrative, unable to accept the truth?

This reminds me of the article I noted earlier where Andrew Levin reminds us that the Fed's written policy is to extinguish too-high inflation with rate hikes that go some extent beyond inflation. Markets seem to be assuming rate hikes will peak somewhere at 1-2% less than inflation, instead of 1-2% more than inflation. We can't comprehend a 6.5-7.5% Fed Funds Rate because the implications for housing, bonds, stocks, and banks are too frightening. It was a 4.25% increase in the FFR that preceded the 2008 Financial Crisis, and we'd need more hikes than that to catch up with 5.5%, much less suppress it.

Even the most hawkish people on inflation assume, as does the bond market, that inflation will fall quickly, either due to the Fed's small countermeasures, the end of stimulative policy, or a disinflationary recession. Nobody but a few crazy retail investors and gold bugs expect 5%+ numbers to persist through mid-2023, with the Fed making half-point rate hikes all along the way up to 6 or 6.5%. That outcome would spell doom for the financial sector.

Another take on the Fed's gradualistic approach is that they feel they've been too knee-jerk reactive in the past, and they want to make decisions based on many months / years of data. They didn't stop QE or raise rates in 2021 because they didn't want to move too soon, and they will move slowly against inflation because they don't want to overshoot. However, policy will still be stimulative (FFR < inflation) six or twelve months from now unless a recession happens and unless it is severe.

[MustacheAndaHalf]

Given how 2018 lacked inflation, I would avoid using it as a model for Fed behavior in the current 8% inflation environment.  Consider for a moment that Fed Chair Powell and the other members do this as their job.  It's very human to want to keep a job, take fewer risks, and take drastic action only when justified - that, to me, explains the Fed.  A group of cental bankers doing their jobs - and keeping their jobs.

One thing the Fed does not get enough credit for: convincing markets to price in future rate hikes.  It's true the Fed is way behind, but some of that gap is mitigated by the market viewing the Fed as reliable and transparent.  One analyst joked she's surprised Chair Powell isn't going door to door telling people about the 0.50% rate hike.  This has allowed the Fed to have 0.25% of Fed funds rate, while actually having 2.5% to 3.0% of rate hikes priced in.  The higher inflation goes, the more this dynamic matters in pricing in rate hikes early.

This Fed has been more direct than past Feds, which allows that dynamic.  On the flip side, I suspect data driven is their phrase for refusing to predict.  If they look at facts, those facts describe the past, so data driven means only looking at past data.  When they give informal guidance, I think they go beyond data driven and give predictions and estimates.  Maybe this is their way to represent both the base case and the possible scenarios?  But I view their sticking to data as a lagging way to handle facts, and makes them more likely to fall behind on inflation.

Your mention of Andrew Levin got me searching further, especially after learning he worked at the Federal Reserve Board for decades:

"Right now the underlying level of inflation is running at about 5% once you take out transitory factors, so the inflation-adjusted interest rate is deeply negative (about -4%). Getting to neutral, as Fed Chairman Jerome Powell said himself Wednesday, is still a long way off."
https://www.washingtonpost.com/business/energy/why-the-federal-reserve-keeps-underestimating-inflation/2022/05/02/03c055fe-ca0c-11ec-b7ee-74f09d827ca6_story.html

I did not realize someone with decades of Federal Reserve Board experience had a similar conclusion as mine - that's reassuring and interesting.  This is less about confirmation bias than feeling entirely isolated in a view that seems reasonable.  By getting others with similar views, I can also hopefully understand what risks they see - which are also risks to my investment approach.  For example, I hold inverse bonds which do extremely well if the Fed shocks the market by raising rates more than expected.  But once inflation is broken, I need to get out before rates crash.

Most investors have a mix of stocks and bonds right now, and I understand it could be painful.  So I try not to mention my gains outside my journal, but I hold 2/3rds cash and 1/5th bearish investments.  Given the general dislike of Kathy Wood's ARKK fund, I figure revealing my SARK positiion won't stir up as much resentment, even if it's up +23% since Friday (5/6).  Where most people "buy & hold", I'm closer to "sell short and hold" for now.  So my status quo and bearish thesis are reflected in my active investments and large cash position.

Putting things in perspective, the market is back to the start of 2021.  Financial TV talks of "capitulation", of signs of a bottom.  And who among us can forget the dreaded -8% crashes of years past?  Because that's all the market is down in the past 12 months... 8%.  I predict it gets worse, but that's where we are right now.

[PDXTabs]

More importantly, reports indicate that things like new vehicles, air fares, and shelter contributed the most to core CPI. If people are scrambling for new cars and plane tickets, that does not scare me as much as if oil prices were going to the moon. Interest rate hikes will take care of the shelter component in time.

Anecdatally, I just purchased airfare to Scotland for more-or-less exactly what I paid in 2016 on the exact same airline. But the fare structure has changed a lot and I had to pay to choose seats and I think I'll also have to pay extra if I choose to take any check luggage. If I was willing to take random seats it would have actually been substantially less than six years ago.

[ChpBstrd]

Here's an interesting read about how to lie or deceive oneself with statistics. Last month's 12 month inflation number reached a 40 year high over 8% AND monthly annualized inflation fell to about 4%. Both statements are true, depending upon where you start measuring. The question of whether inflation is rising or falling is not clear - it depends on where you measure.

https://www.marketwatch.com/story/inflation-may-be-a-lot-lower-than-anyone-thinks-even-the-fed-11653382237?mod=home-page

Likewise, the peak of this inflationary cycle will not necessarily be announced by the 12 month number. It will be announced by the monthly annualized change number. However the monthly numbers are very noisy and subject to revision. So your choice is between (a) way behind the curve numbers, or (b) numbers where the noise is louder than the signal.

Another low monthly number could send investors stampeding into a bear market rally, but the Fed might keep hiking anyway. They seem to be looking at even longer time-spans.

[MustacheAndaHalf]

Here's an interesting read about how to lie or deceive oneself with statistics. Last month's 12 month inflation number reached a 40 year high over 8% AND monthly annualized inflation fell to about 4%. Both statements are true, depending upon where you start measuring. The question of whether inflation is rising or falling is not clear - it depends on where you measure.

https://www.marketwatch.com/story/inflation-may-be-a-lot-lower-than-anyone-thinks-even-the-fed-11653382237?mod=home-page

Likewise, the peak of this inflationary cycle will not necessarily be announced by the 12 month number. It will be announced by the monthly annualized change number. However the monthly numbers are very noisy and subject to revision. So your choice is between (a) way behind the curve numbers, or (b) numbers where the noise is louder than the signal.

Another low monthly number could send investors stampeding into a bear market rally, but the Fed might keep hiking anyway. They seem to be looking at even longer time-spans.

When you say "your choice is between (a) ..., or (b) ..." those aren't the only choices.  Can't I dig into CPI-U data?  Can't the Fed view "Core CPE" data?  It may be valuable to consider other possibilities before concluding there are just 2 choices.

When I analyze inflation, I use high quality sources.  For example, I can view BLS inflation data to compare inflation for the months of March and April:

other: from .3 to .6 with weight 78.34 (= .3 x .7834) = .235
food: from 1.0 to .9 with weight 13.36 (= -.1 x .1336) = -0.134
energy: from 11.0 to -2.7 with weight 8.3 (= -13.7 x 0.083) = -1.1371
https://www.bls.gov/news.release/cpi.nr0.htm (monthly numbers)
https://www.bls.gov/news.release/cpi.t01.htm (weights)

Taking raw BLS data and comparing April with March, I conclude 75% of the change in inflation came from falling energy prices.  Although "other" is about 10x more important than inflation, the raw amount of change was 45x larger with energy.  Another way to poke a hole in this columnist's article is to ask what was inflation without energy?

This columnist used St Louis Fed data, as shown in their graph.  But did you notice every number they cite about inflation is found in that graph?  They should have dug into energy vs food vs other inflation - but it seems like they don't have a graph for that.

Even without looking at inflation data, you can reason that a war involving two big energy suppliers is going to spike inflation when it starts.  It wouldn't be surprising to see volatility that falls over time - which is what the inflation data shows.

Overall I see a random columnist putting "may be" in a column title, focusing on one graph, and ignoring other data and news.  To me, that article is not a useful source of information.

[ChpBstrd]

I'm very reluctant to wade into the details of where inflation is coming from - food, fuels, whatever... - because these data are very noisy and because they tempt us to invest with false confidence based on compelling narratives that are more likely to be false than true. You are correct, @MustacheAndaHalf that many articles with a target word count only focus on one detail - such as measurement issues.

We commit the conjunctive fallacy when we think statements with more details are more likely to be true than stories with fewer vivid details, even though reducing the number of conditions logically makes a story have fewer dependencies. E.g. Linda is a bank teller is thought to be less likely than the combination that Linda is a bank teller and a feminist, even though adding a second condition makes it less likely that the truth is she is both. Similarly, we might string together one possible chain of future events out of thousands of possible directions inflation could go, or come up with string after string of very specific excuses for our inflation framework being out of line with incoming evidence.

Arthur Burns did this as Fed chair in the 1970's, when his narrative about causes for inflation bounced all over some very specific places: OPEC, unions, consumer expectations, regulations, specifics in contracts, cost of living adjustments, activities of other central banks, etc... Burns even invented the "core" measures when he asked his staff to remove food and energy from the inflation stats to give him a more acceptable number. The US went through years of dwelling on these details until Paul Volker came in with a simpler theory, hiked rates, slowed monetary velocity, and ended the Great Inflation.

Here's a summary:

Under Volcker’s predecessor, Arthur Burns, the Fed had become convinced that inflation was part of the economy’s institutional fabric. The price level was thought to have less to do with monetary policy than with the power of labor unions, cost-of-living wage indexation, and regulatory pressures on costs stemming from environmental protection, occupational safety, and pension benefits. Burns argued that oil and food-price shocks reinforced the institutional biases of an inflation-prone economy.

https://www.marketwatch.com/story/i-knew-paul-volcker-who-slew-the-great-inflation-and-jerome-powell-is-no-paul-volcker-11653500709?mod=hp_minor_pos26

Also from Stephen Roach:

Like business cycles, he believed price trends were heavily influenced by idiosyncratic, or exogenous, factors—“noise” that had nothing to do with monetary policy.

Only in 1975, did Burns concede—far too late—that the United States had an inflation problem. The painful lesson: ignore so-called transitory factors at great peril.

This was a blunder of epic proportions. When oil prices quadrupled following the OPEC oil embargo in the aftermath of the 1973 Yom Kippur War, Burns argued that, since this had nothing to do with monetary policy, the Fed should exclude oil and energy-related products (such as home heating oil and electricity) from the consumer price index. The staff protested, arguing that it made no sense to ignore such important items, especially because they had a weight of over 11% in the CPI. Burns was adamant: If we on the staff wouldn’t perform the calculation, he would have it done by “someone in New York”—an allusion to his prior affiliations at Columbia University and the National Bureau of Economic Research.

Then came surging food prices, which Burns surmised in 1973 were traceable to unusual weather—specifically, an El Niño event that had decimated Peruvian anchovies in 1972. He insisted that this was the source of rising fertilizer and feedstock prices, in turn driving up beef, poultry, and pork prices. Like good soldiers, we gulped and followed his order to take food—which had a weight of 25%—out of the CPI.

We didn’t know it at the time, but we had just created the first version of what is now fondly known as the core inflation rate—that purified portion of the CPI that purportedly is free of the volatile “special factors” of food and energy, where gyrations were traceable to distant wars and weather. Burns was pleased. Monetary policy needed to focus on more stable underlying inflation trends, he argued, and we had provided him with the perfect tool to sharpen his focus.

Over the next few years, he periodically uncovered similar idiosyncratic developments affecting the prices of mobile homes, used cars, children’s toys, even women’s jewelry (gold mania, he dubbed it); he also raised questions about homeownership costs, which accounted for another 16% of the CPI. Take them all out, he insisted!

By the time Burns was done, only about 35% of the CPI was left—and it was rising at a double-digit rate! Only at that point, in 1975, did Burns concede—far too late—that the United States had an inflation problem. The painful lesson: ignore so-called transitory factors at great peril.

https://www.marketwatch.com/story/the-ghost-of-arthur-burns-haunts-a-complacent-federal-reserve-thats-pouring-fuel-on-the-fires-of-inflation-11621971073

Burns committed the conjunctive fallacy by making excuse after excuse for inflation, until the weight of all the excuses collapsed and a simpler theory won out. Similarly, my theory of inflation is that it is a way of measuring the velocity of money. That's a boring textbook summary, but it keeps us focused on what matters: the supply of money, consumer behavior in earning/spending that money, and interest rates.

We all know the simple cause of inflation: $4T in stimulus in 2020, 2021, and part of 2022 are now bouncing around the economy at high speed being spent and earned over and over again, creating shortages of goods and labor. We also all know the solution: higher interest rates and selling assets from the Fed balance sheet. These actions slow monetary velocity and take down inflation and none of this is controversial or requires a wade into the weeds.

[ChpBstrd]

The new PCE numbers are out:

https://www.bea.gov/news/2022/personal-income-and-outlays-april-2022

As with CPI for the same month of April, we saw a modest decline in the rate of growth - 6.3% annualized in April vs. 6.6% in March. This is not surprising, but it's kind of another point in favor of the idea that inflation peaked in March, and then reacted downward in response to the end of QE, the quarter-point March rate hike at the short-duration end of the curve, and a rapid change in market expectations that almost doubled interest rates at the long-duration end of the curve.

Philly Fed President Patrick Harker recently said "I anticipate a sequence of increases in the funds rate at a measured pace until we are confident that inflation is moving toward the FOMC’s inflation target." The question is... exactly how many data points - or at what threshold - would the FRB decide that their policy was restrictive enough to send inflation on a downward trajectory that eventually ends up at 2%? Ben Bernacke recently opined that he thinks the Fed will drop inflation within the next "couple of years", but if PCE and/or CPI continue dropping at a 0.3% annualized pace per month we will hit about 2% sometime next summer. For example:

April 22: 6.3%
May 22: 6%
Jun 22: 5.7%
Jul 22: 5.4%
Aug 22: 5.1%
Sep 22: 4.8%
Oct 22: 4.5%
Nov 22: 4.2%
Dec 22: 3.9%
Jan 23: 3.6%
Feb 23: 3.3%
Mar 23: 3%
Apr 23: 2.7%
May 23: 2.4%
Jun 23: 2.1%

At what point on this hypothetical post-peak continuum would the rate hikes and QT stop? When will the Fed be "confident"? And, again, what is the neutral rate?

All this matters a lot WRT stock valuations at the end of the rate hike cycle. My wild guess is that we see 0.5% rate hikes in June, July, and September, followed by 0.25% hikes in November, December, and January. After that point, we either have a recession or the Feds let the trend ride a while. Events like this would only bring rates up to 3-3.25%. If that's the future, a fair earnings yield on the S&P 500 might be 5-5.25%, which would be a PE of 19-20. Stocks are rallying on the news because we're already there, and earnings are growing.

The inflation rate fell in April despite a general increase in the GSCI Commodities Index and rising oil prices. If demand destruction is occurring due to high commodity prices, then maybe these prices can't rise forever. The PCE index, often referred to as what actually gets sold (as opposed to CPI - the price of a basket of stuff), implies this conclusion. We are about to get into a cycle like 2018-2019 where all bad news is interpreted as good news due to the effect on interest rates.

My bearish-to-neutral approach has beaten the market for the entire 3-month time I've been using it, and saved me from maybe $100,000 in losses, but the odds are against bearish/neutral portfolios in the long term. Eventually shorts have to collect their alpha or lose it. I'm starting to think the risks of missing an inflation down-slope are outweighing the risks of going long. Now that the future direction is much less clear, I'm thinking I should go long and hedge my risk with options or by investing in small/mid cap value.

The S&P600 small cap index and S&P400 mid cap index have both already fallen to a forward PE ratio of 12, according to Yardini. That's near 2020 lows, and not a scary distance higher than 2008 lows. Maybe these are the PE ratios in the low teens I was hoping for. So I'll be moving into IVOV (Vanguard mid-cap value) and maybe some VIOV (Vanguard small-cap value), unhedged. I'll also move into a smaller amount of SPY, hedged. Finally, I sold a few puts on CRM because I think they are probably doing better than most people think in this environment where businesses are flush with cash and under pressure to increase efficiency (lack of workers, margin pressures), similar to 2019 and priced the same too). My deep-ITM covered call positions should close me out of SQQQ this weekend, and just like that I'll be long again.

 

[MustacheAndaHalf]

That article is an amazing find - economist Stephen Roach worked for the Federal Reserve in the 1970s.  He was there, on the inside.  In my view, his career and insider position makes him an expert in comparisons to the 1970s.  (I assume Wikipedia, Yale and CNBC providing consistent details about Mr Roach means he is who he says he is - this is more important when I view someone as an expert)

"Roach, a Yale University senior fellow and former Federal Reserve economist, calls stagflation his base case and the peak inflation debate absurd."
https://www.cnbc.com/2022/05/19/stephen-roach-gives-stagflation-warning-calls-peak-inflation-absurd.html

In that article and the two you posted, the most stunning information for me was why food & energy are excluded from the Fed's measure of inflation: because that's what Fed Chair Burns did in the 1970s.  On the way to being very wrong about inflation, he kept saying "throw it out!" to more and more parts of CPI, until he was left with 1/3rd of the original measures.  He was wrong for years, starting with excluding food & energy, and followed by excluding 2/3rds of what matters to inflation.  And now we have "Core CPE", where "Core" means without food & energy.  I imagine the Fed looks at both, but focusing on Core CPE may be a mistake.

Reading those articles, economist Steven Roach's comparison to the 1970s is brutal.  There's no way a young economist could have stopped the policies of a pre-eminent econimist leading the Fed, so I hope he doesn't fault himself for that.  But his observations, and his sense of deja vu... that is very telling.  Fed Chair Powell has talked about things he expects to all come down (energy, food, semiconductors, automobiles) ... it's not a good sign.

Maybe, since I dig into data, I should make a "Powell CPI" and "non-Powell CPI"?  Meaning look at the categories he views dismissively, and put those in "non-Powell CPI", and put the rest in "Powell CPI".  I would re-use the weights and numbers in the detailed CPI reports to come up with my own two inflation measures.  I might be able to better see the gap between what Powell views as inflation, and what he's mentally giving less weight.  It's also such an obnoxious idea, that I doubt the Fed members have thought of it.

You mentioned the neutral rate, which I view as the inflation rate the Fed prefers.  Last year the Fed talked about a goal of having average inflation around 2%, so the end of your data series might be their target.  The Fed also mentioned that after a period of low inflation, in order to achieve that 2% average, they were going to allow inflation to run hotter.  (Where is that "Mission Accomplished" banner when we need it?)

[PDXTabs]

The new PCE numbers are out:

https://www.bea.gov/news/2022/personal-income-and-outlays-april-2022

As with CPI for the same month of April, we saw a modest decline in the rate of growth - 6.3% annualized in April vs. 6.6% in March. This is not surprising, but it's kind of another point in favor of the idea that inflation peaked in March, and then reacted downward in response to the end of QE, the quarter-point March rate hike at the short-duration end of the curve, and a rapid change in market expectations that almost doubled interest rates at the long-duration end of the curve.

Yes, but energy prices were less up in April than March (Page 12: https://www.bea.gov/sites/default/files/2022-05/pi0422.pdf). I'm not sure that will continue to be the case.

[ChpBstrd]

Yea, Mr. Roach was on the ground floor watching disastrous decisions being made like some kind of anti-apprentice. If he's calling today's approach to inflation weak-handed, that is worth listening to, because he's seen weak-handed. However, as Ben Bernacke pointed out on 5/23, today's Fed exists in a very different political world than the Fed of Arthur Burns:

...the Powell Fed seems to have the support from the Biden White House and both parties in Congress, he said.

Fed Chairman Jerome Powell “has worked really hard to mend relations” with Congress, and lawmakers seem to be supporting the Fed’s inflation-fighting plans, Bernanke said.

That wasn’t the case in the late 1970s, when Congress was pushing for pro-employment policies despite the high inflation.

Another difference from the high inflation era is that former Fed chair Arthur Burns didn’t think that the Fed was an effective tool in fighting inflation, Bernanke said.

https://www.marketwatch.com/story/fed-will-succeed-in-bringing-inflation-down-over-next-couple-of-years-bernanke-says-11653322132?mod=economy-politics

If we extend Bernacke's logic, we should panic about inflation if we see politicians pressuring the FRB to keep rates low, like they did in the 1970's, or attempting price controls. That scene would cause markets to lose faith in the FRB's ability to tackle inflation.

Additionally, poor Arthur Burns had only one tool at his disposal: overnight interest rates*. Today's FRB uses both interest rates and QE/QT to directly add and subtract from the money supply, giving it an ability to manually shape the interest rate curve to some extent. The FRB didn't just raise rates half a percent, it also began the disposal of hundreds of billions of dollars in assets - actions that will remove hundreds of billions of dollars from the real economy and reduce the velocity of money.

This segues us to the point that prior to April, the Fed was buying tens / hundreds of billions of dollars in assets on the open market, attempting to flood the market with dollars in order to avoid a depression. The change from buying tens of billions in assets to selling them was probably a bigger deal than the rate hikes we've seen so far. I don't see Stephen Roach incorporating this concept into his predictions. Back in 2018, he was critical of the side effects of the QE that occurred since 2008, implying that maybe it wasn't a big contributor to the recovery. 

https://www.youtube.com/watch?v=2lXii-U-POg

I think QE/QT has a much bigger effect than Roach allows. I also think it should be the Fed's primary tool rather than interest rates, but that's another story. Roach, seems to be singularly focused on interest rates, and his main concern is deeply negative real interest rates. I see Roach's prediction as being from another era, before the existence of QE/QT. He completely dismisses the impact of $30B per month of treasuries and another $17.5B in mortgage backed assets being sold into the market each month for the next 3 months, until the pace of asset sales abruptly doubles in September (https://www.federalreserve.gov/newsevents/pressreleases/monetary20220504b.htm). How does that not move the needle, compared to a year ago when the opposite was occurring?

Your suggestion to create a Powell/non-Powell CPI is amusing, but would be a PITA in real life. I think the standard non-core CPI calculation will do for me. I have confidence in the way CPI and PCE are calculated. I'm particularly interested in how quickly they can change. I suspect the increases over 2021 are a sign of how fast we might see decreases in 2022. CPI's annual rate of change went up 6% in that time. It could, in theory, fall just as fast now that the causes have been removed.

I should clarify my earlier statement about not getting into the weeds or coming up with one-off narratives to explain or predict inflation. I do think $4T in stimulus is an explanation that cannot be ignored, but that's because it is an input into a model of monetary velocity that includes money supply, consumer behavior, and interest rates. The government made big changes to all 3 in 2020-22, so that is a lot more relevant to me than details like the price of gasoline, the war on the other side of the planet, or Chinese lock-downs that probably aren't as dramatic or widespread as we're led to believe anyway.

So I'm going to differ from Stephen Roach and venture into what I perceive to be the safest parts of the market. Even if I didn't pick the peak of inflation, I will still walk away with market-beating returns since the Russian invasion. Wish me luck!

*Technically, there is/was one more tool. In an emergency, bank reserve ratios could be changed, but the riskiness of such a move means reserve ratios are not routinely used to adjust policy.

[MustacheAndaHalf]

The new PCE numbers are out:

https://www.bea.gov/news/2022/personal-income-and-outlays-april-2022

As with CPI for the same month of April, we saw a modest decline in the rate of growth - 6.3% annualized in April vs. 6.6% in March. This is not surprising, but it's kind of another point in favor of the idea that inflation peaked in March, and then reacted downward in response to the end of QE, the quarter-point March rate hike at the short-duration end of the curve, and a rapid change in market expectations that almost doubled interest rates at the long-duration end of the curve.

Yes, but energy prices were less up in April than March (Page 12: https://www.bea.gov/sites/default/files/2022-05/pi0422.pdf). I'm not sure that will continue to be the case.

According to CPI-U inflation data, March 2022 energy CPI-U inflation was +11.0%, and April -2.7%.
https://www.bls.gov/news.release/pdf/cpi.pdf#page=2

You can watch the news to see what Russia has done during it's invasion of Ukraine - immoral might be a good description.  What's interesting is the reaction of the largest economy in the EU, Germany: they not only keep paying Russia for gas, they gave in to Russian demands to be paid in Russian Rubles.  Poland refuses, but Italy has done the same.  I guess moral pressure isn't as great as gas pressure.

Uncertainty over Russian sanctions pushed oil & gas prices up in March, but volatility fell in April.  Based on the situation I describe above, and the analysis of energy prices below, I suspect May could show negative energy inflation numbers.  Maybe I should reduce some of my positions and wait for August.

"Gasoline futures were at $3.8 per gallon, easing from the record high of $4.06 touched on May 16th amid recession concerns. Fears of economic slowdown were exacerbated after work from home measures were extended in Beijing as covid cases in the area accelerated, while reports that the EU is unlikely to approve its Russian oil embargo in next week’s leader meeting also reduced energy prices. Still, prices remain close to record highs ahead of the US peak driving season, expected to kick-off following Memorial Day weekend at the end of May. At the same time, EIA data showed gasoline stocks shrank by 4.8 million barrels in the week ending May 13th."
https://tradingeconomics.com/commodity/gasoline

[PDXTabs]

Savings Rate
The counterpoint to this argument is the observation that the Personal Savings Rate has plummeted to below the pre-COVID trend. Maybe consumers are flush with stimulus cash, feel secure in their employment, and don't feel the need to save any more? Or maybe they have already blown through their stimulus cash and are now spending out of their savings jars? Or maybe they're not saving as much because they're buying stuff now in anticipation of rising inflation later. In any case, maybe consumers don't have a pile of savings to sustain their current spending spree? The high savings rates during 2020-2021 were a bullish sign, but now we've gone the other direction. This supports the case for falling monetary velocity.
Savings Rate Source: https://fred.stlouisfed.org/series/PSAVERT

The April data is now out and is lower again.
4/21 - 12.6%
5/21 - 10.4%
6/21 - 9.5%
7/21 - 10.5%
8/21 - 9.8%
9/21 - 8.1%
10/21 - 7.5%
11/21 - 7.6%
12/21 - 8.7%
1/22 - 6.0%
2/22 - 5.9%
3/22 - 5.0%
4/22 - 4.4%

But I'm not sure how much it matters because I'm not sure how much people have saved away that they are willing to spend.

[ChpBstrd]

Savings Rate
The counterpoint to this argument is the observation that the Personal Savings Rate has plummeted to below the pre-COVID trend. Maybe consumers are flush with stimulus cash, feel secure in their employment, and don't feel the need to save any more? Or maybe they have already blown through their stimulus cash and are now spending out of their savings jars? Or maybe they're not saving as much because they're buying stuff now in anticipation of rising inflation later. In any case, maybe consumers don't have a pile of savings to sustain their current spending spree? The high savings rates during 2020-2021 were a bullish sign, but now we've gone the other direction. This supports the case for falling monetary velocity.
Savings Rate Source: https://fred.stlouisfed.org/series/PSAVERT

The April data is now out and is lower again.
4/21 - 12.6%
5/21 - 10.4%
6/21 - 9.5%
7/21 - 10.5%
8/21 - 9.8%
9/21 - 8.1%
10/21 - 7.5%
11/21 - 7.6%
12/21 - 8.7%
1/22 - 6.0%
2/22 - 5.9%
3/22 - 5.0%
4/22 - 4.4%

But I'm not sure how much it matters because I'm not sure how much people have saved away that they are willing to spend.

Maybe this metric helps with the interpretation?

https://fred.stlouisfed.org/series/CDCABSHNO

According to this, consumers are probably flush with cash. Maybe COVID restrictions and fears are gone, but now consumer spending is being held back by shortages? If I’m interpreting it correctly, this metric is very suggestive of inflationary conditions.

[wageslave23]

Savings Rate
The counterpoint to this argument is the observation that the Personal Savings Rate has plummeted to below the pre-COVID trend. Maybe consumers are flush with stimulus cash, feel secure in their employment, and don't feel the need to save any more? Or maybe they have already blown through their stimulus cash and are now spending out of their savings jars? Or maybe they're not saving as much because they're buying stuff now in anticipation of rising inflation later. In any case, maybe consumers don't have a pile of savings to sustain their current spending spree? The high savings rates during 2020-2021 were a bullish sign, but now we've gone the other direction. This supports the case for falling monetary velocity.
Savings Rate Source: https://fred.stlouisfed.org/series/PSAVERT

The April data is now out and is lower again.
4/21 - 12.6%
5/21 - 10.4%
6/21 - 9.5%
7/21 - 10.5%
8/21 - 9.8%
9/21 - 8.1%
10/21 - 7.5%
11/21 - 7.6%
12/21 - 8.7%
1/22 - 6.0%
2/22 - 5.9%
3/22 - 5.0%
4/22 - 4.4%

But I'm not sure how much it matters because I'm not sure how much people have saved away that they are willing to spend.

Maybe this metric helps with the interpretation?

https://fred.stlouisfed.org/series/CDCABSHNO

According to this, consumers are probably flush with cash. Maybe COVID restrictions and fears are gone, but now consumer spending is being held back by shortages? If I’m interpreting it correctly, this metric is very suggestive of inflationary conditions.

We should just do a $1400 per person bonus tax in order to stop inflation.

[MustacheAndaHalf]

I'm guessing most people are mentally revising history, and instead of viewing Omicron as uncertain in 2021 Q4, are thinking it was mild the whole time and everyone should have known.  It's a very human bias, but it leads to criticisms of the Fed that are not accurate given information known at the time.  I would place $1400 stimulus checks from 2021 in that category, too.

This past week Fed member Bostic said a pause in September could make sense.  Markets reacted by lowering the chance of a 0.50% rate hike in September, which previously had 100% certainty.  Right now bonds yield 3%, suggesting a 1.75% or 2.25% Fed funds rate is priced in.  I think the Fed's own uncertainty is being expressed so that markets don't treat rate hikes as certain.  If I was a reporter following the Fed, I would ask the cutting question of Fed Chair Powell "Do you agree with Bostic?"

Fed Chair Powell has said it's his job to engineer a soft landing, not make the odds.  In this metaphor, Fed Chair Powell is the pilot.  The Fed funds rate is one control of the plane, and the plane is the U.S. economy.  Inflation would be a storm.  Will the storm fade rapidly or remain strong?  If the storm fades, the best choice is bringing the U.S. economy in for a soft landing in calm weather - in low inflation.  If the storm of inflation persists, low Fed funds rates leave the plane deeper inside the storm, and requiring a greater climb to get on top of inflation - above the storm.  I suspect this latter, more probable scenario plays out, leaving the climb even steeper owing to time lost hoping for a soft landing.  Unfortunately, a long enough storm and the plane stalls... falling from an even greater height without fuel, and crashing.  The Fed can prepare for a soft landing or prepare for persistent inflation, but it can't do both at the same time.  I guess we'll see what September brings: my base case was a 0.75% rate hike, while the Fed is deciding between 0% and 0.50%.

[ChpBstrd]

Maybe the theory of a 2.5% "neutral rate" isn't dead. Mary Daly was quoted on CNBC as saying:

“We need to get the rate up to neutral, which I put about 2.5% in nominal terms. We need to do that expeditiously,”

https://www.cnbc.com/video/2022/06/01/i-see-50-basis-point-hikes-the-next-couple-of-meetings-says-san-francisco-fed-president-and-ceo.html?&qsearchterm=fed%20daly

With this comment, and Bostic's recent comment about a potential pause in September, it seems like the Fed has adopted a two-step process to fight inflation:

1) Get to the 2.5% "neutral rate". This would imply a 50 basis point hike at the Sept. or Nov. meetings.

2) Make another decision in September. Daly wants to "look around and see what else needs to be done" at that time because "it's too early in my judgment to decide we're doing one thing or another." This is in line with Bostic's recent comment that “I want to make sure I truly understand the pace of change that’s associated with our policy response,” because the market's sudden swing "was far stronger than what we’ve historically seen." And as J. Powell himself said, "the decision about how high to go will be on the table to be made when we reach neutral".

Presumably, economic conditions could be very different four months from now, especially after such a rapid-fire sequence of rate hikes, and the FOMC members want to leave themselves some room to either accelerate rate hikes or pause, depending on conditions. They might also want to take a couple months off after achieving "neutral" in order to gauge the trends they are creating, before proceeding. I think they're communicating this mental framework to us quite transparently.

For example we can imagine two possible Septembers:

     a) Slowing September: Sudden rate hikes and QT lead to rising unemployment, economic growth stats near stall speed, and recession seems imminent. The inflation rate is in a multi-month downtrend. The FOMC either holds off a Sept. rate hike until their Nov. meeting, or goes with a 0.25% hike.

     b) Speeding September: The Fed's rate hikes and QT are too little too late. CPI continues to rise between 6% and 10%, and the economy continues to accelerate amid shortages of goods and labor. The FOMC does a 0.5% hike in Sept. and lines up another 0.5% for Nov.

Scenario a) is counterintuitively the best case scenario for stocks, because it implies a lower discount rate, and therefore higher valuations for shares. Scenario b) might be a sign that inflation is rising faster than the FOMC can hike rates, that it won't be tamed until rates exceed inflation, and that valuations are heading back to levels last seen in the era of Paul Volker.

[ChpBstrd]

Let's not forget to account for quantitative tightening. On May 4, Powell said that he estimates QT will have an effect similar to a 0.25% interest rate hike. Listen to his dismissive answer to a question about the timing and effect of QT in the following interview starting at the 37:12 mark.

https://www.federalreserve.gov/monetarypolicy/fomcpresconf20220504.htm

"Why June 1? Just pick a date.... no macroeconomic significance."

He also said the effect was too uncertain to estimate and "I can't be any clearer, there won't be any clearer." He said a mainstream estimate is that hundreds of billions of dollars (trillions?) in QE/QT is about like a quarter-point rate hike over the course of a year. His body language conveys frustration at the immeasurability of this intervention, its lack of fit with existing models, or its perceived inefficacy. He said the plan is for the interest rate to be the "active tool of monetary policy".

Perhaps this is the assumption at the root of the Fed's errors. If QE/QT is a more powerful medicine than the Feds assume, that explains why they didn't immediately cut QE back in 2021 when inflation started ramping up. They thought QE was having a weak effect, so they didn't see the connection to inflation, and let QE continue until March 2022.

Now we have the Ukraine war and Chinese lockdowns to blame for high inflation, so maybe the lesson about QE was made ambiguous (even though QE and rising inflation preceded these causes). These excuses could allow the FOMC to continue thinking that QE/QT are symbolic gestures, when in fact they are swinging financial conditions and inflation dramatically. Much of the post-pandemic stimulus was a form of QE directed at consumers. The theoretical basis for reacting to a financial crisis this way goes back to Keynes, and was proven in the GFC, so I have no idea why Powell is so dismissive of its effect on inflation. It also doesn't make sense in light of how slowly the Fed has made changes to QE/QT over the past year and a half. Why not move more dramatically if QE/QT don't matter? Perhaps the Fed sees QE/QT as having a market stability function, rather than directly controlling money supply, and so they don't want to move it too dramatically?

Lastly, while I was reviewing Powell's May 4 press conference, I heard him refer multiple times to "financial conditions" and realized he was alluding to the Chicago Fed National Financial Conditions Index.
https://fred.stlouisfed.org/series/NFCI

This index is kinda a big deal. It is a recession predictor on par with inverted yield curves. Higher values mean tighter financial conditions (reduced availability of loans, reduced liquidity, etc). I am including this metric in the thread because it needs to be monitored regularly. It is quickly arcing toward conditions that in the past were associated with recessions. This is probably why bond markets still anticipate low long-term inflation. Maybe they're betting on a recession scenario because it's clear to at least some bond market participants that the Fed underestimates the force of QT, and is overdosing the patient with a powerful drug cocktail that will lead to recession.

These thoughts about continued faulty assumption about QE/QT, the Fed's recent history of missing a rapid increase in inflation, the Fed's continuing dismissal of QE/QT, the bond market's breakeven predictions, and the rising NFCI, all make me wary of making a big investment in tech stocks or recession-sensitive industries. If the Fed is leading us into a recession with an continued unawareness of the power of QE/QT, then that means the consumers whose consumption is now limited by inflation are about to be limited by job losses. I'm getting some buyer's remorse about my small-cap value and mid-cap value ETF purchases.

[wageslave23]

What shocks me is that it is so easy for layman to second guess these appointed officials who should be the smartest people on the room with access to the most information.  It's not that Yellen and Powell were so wrong about inflation last year, it's that most economists thought they were wrong and were saying so last year. That to me is alarming. Now you and many economists are justifiably questioning the feds response to inflation this year and whether they will be able to navigate a soft landing. It's frustrating that it seems to be so easy to critique their analysis and actions in real time and then see that criticism play out.  For example, Warren Buffet might differ in opinion from other economists and he might be wrong on an investment and I could disagree with his investment decision but most intelligent economists and investors aren't going to say "what the hell is he doing? He's completely misreading this".  I'm not sure if this is because Powell and Yellen are operating under faulty economic theories, politically motivated, or just nor very intelligent.  I don't which would be scarier, but still alarming how little confidence there is in the feds decision making given how much power they wield. Am I totally off base?

[MustacheAndaHalf]

ChpBstrd - Thanks for sharing the graph of "financial conditions index".  Two things I find interesting: (1) right now the graph is not at a dangerous level, and (2) the graph is changing at a very fast rate, and more consistently upwards than prior moves (over the past several years).  I suspect this graph could explain why the Fed seems slow to react, if they indeed rely on it.

I disagree that "high inflation" started with Russia's invasion of Ukraine on Feb 24, 2022 (China's lockdowns followed later).  Remember the Fed calling inflation "transitory" for most of 2021?  That was because inflation was a growing problem, not because there was low inflation before Feb 24 2022.

Social security payments are indexed to inflation, so I'm using their data to demonstrate inflation.  If you divide Jan 2022 by Jan 2021, you will see 8% inflation the month before Russia invaded Ukraine.  I consider the highest inflation in 40 years to be high inflation, which was before the events you described.
https://www.ssa.gov/oact/STATS/cpiw.html

Speaking of social security, I don't understand how that fits into the Federal budget.  I know it's a huge area of spending, and it's non-discrentionary (Congress can't change it).  But I don't understand if inflation impacts how much money Congress allocates to social security.  I wonder if that could leave less money for other government programs, and require Congress make some cuts.  If both consumers and the government are spending less, that could amplify the economic downturn.  (But I'm investing against the market, so I'm looking for angles like that)

[ChpBstrd]

What shocks me is that it is so easy for layman to second guess these appointed officials who should be the smartest people on the room with access to the most information.  It's not that Yellen and Powell were so wrong about inflation last year, it's that most economists thought they were wrong and were saying so last year. That to me is alarming. Now you and many economists are justifiably questioning the feds response to inflation this year and whether they will be able to navigate a soft landing. It's frustrating that it seems to be so easy to critique their analysis and actions in real time and then see that criticism play out.  For example, Warren Buffet might differ in opinion from other economists and he might be wrong on an investment and I could disagree with his investment decision but most intelligent economists and investors aren't going to say "what the hell is he doing? He's completely misreading this".  I'm not sure if this is because Powell and Yellen are operating under faulty economic theories, politically motivated, or just nor very intelligent.  I don't which would be scarier, but still alarming how little confidence there is in the feds decision making given how much power they wield. Am I totally off base?

To some extent Fed officials get too much grief from pundits and regular people and do a much better job than people give credit for. The internet is FULL of armchair quarterbacks (like myself, lol?) who know exactly enough to be dangerous, and whose egos lead them to declare themselves smarter than people who've devoted their lifetime to economics. It's the parallel to people who self-treat their health problems based on YouTube videos.

My old posts from 2021 can be pulled up to show I was firmly in the flat-out-wrong "transitory" camp because I was thinking about the post-GFC "connundrum" years when tons of QE did not result in rising inflation like many, many people were predicting at the time. It seemed history was repeating itself until it didn't. Perhaps the people who we should have little confidence in are ourselves!

I disagree that "high inflation" started with Russia's invasion of Ukraine on Feb 24, 2022 (China's lockdowns followed later).  Remember the Fed calling inflation "transitory" for most of 2021?  That was because inflation was a growing problem, not because there was low inflation before Feb 24 2022.

Yes, that's what I was saying too - perhaps unclearly. Inflation was high before 2/24/22, but now we have Ukraine and Chinese lockdowns to talk about. The longer we talk about these more recent issues, the more we lose sight of the fundamental causes of inflation that existed before the issues arose. If Fed officials decide most of our inflation problems are coming from these sources rather than monetary policy, they might dismiss them as "transitory" supply-side issues, outside the scope of their demand-side policy tools. More Fed talk about Ukraine and China "excuses" equals higher odds they let inflation run hotter for longer.

Speaking of social security, I don't understand how that fits into the Federal budget. 

SS increases will come out of the same places the rest of Federal spending increases come from: the deficit.

[wageslave23]

What shocks me is that it is so easy for layman to second guess these appointed officials who should be the smartest people on the room with access to the most information.  It's not that Yellen and Powell were so wrong about inflation last year, it's that most economists thought they were wrong and were saying so last year. That to me is alarming. Now you and many economists are justifiably questioning the feds response to inflation this year and whether they will be able to navigate a soft landing. It's frustrating that it seems to be so easy to critique their analysis and actions in real time and then see that criticism play out.  For example, Warren Buffet might differ in opinion from other economists and he might be wrong on an investment and I could disagree with his investment decision but most intelligent economists and investors aren't going to say "what the hell is he doing? He's completely misreading this".  I'm not sure if this is because Powell and Yellen are operating under faulty economic theories, politically motivated, or just nor very intelligent.  I don't which would be scarier, but still alarming how little confidence there is in the feds decision making given how much power they wield. Am I totally off base?

To some extent Fed officials get too much grief from pundits and regular people and do a much better job than people give credit for. The internet is FULL of armchair quarterbacks (like myself, lol?) who know exactly enough to be dangerous, and whose egos lead them to declare themselves smarter than people who've devoted their lifetime to economics. It's the parallel to people who self-treat their health problems based on YouTube videos.

My old posts from 2021 can be pulled up to show I was firmly in the flat-out-wrong "transitory" camp because I was thinking about the post-GFC "connundrum" years when tons of QE did not result in rising inflation like many, many people were predicting at the time. It seemed history was repeating itself until it didn't. Perhaps the people who we should have little confidence in are ourselves!

I disagree that "high inflation" started with Russia's invasion of Ukraine on Feb 24, 2022 (China's lockdowns followed later).  Remember the Fed calling inflation "transitory" for most of 2021?  That was because inflation was a growing problem, not because there was low inflation before Feb 24 2022.

Yes, that's what I was saying too - perhaps unclearly. Inflation was high before 2/24/22, but now we have Ukraine and Chinese lockdowns to talk about. The longer we talk about these more recent issues, the more we lose sight of the fundamental causes of inflation that existed before the issues arose. If Fed officials decide most of our inflation problems are coming from these sources rather than monetary policy, they might dismiss them as "transitory" supply-side issues, outside the scope of their demand-side policy tools. More Fed talk about Ukraine and China "excuses" equals higher odds they let inflation run hotter for longer.

Speaking of social security, I don't understand how that fits into the Federal budget. 

SS increases will come out of the same places the rest of Federal spending increases come from: the deficit.

Whether inflation was transitory or not seems like it was a legitimate question. Something only hindsight could determine.  The idea that the tight labor market and shortage of goods last summer suggested that continuing the accommodative monetary policies was a bad idea seemed universally accepted by everyone I read at the time who are much more knowledgeable than me.

[Fjord]

...

But I'm not sure how much it matters because I'm not sure how much people have saved away that they are willing to spend.

Maybe this metric helps with the interpretation?

https://fred.stlouisfed.org/series/CDCABSHNO

According to this, consumers are probably flush with cash. Maybe COVID restrictions and fears are gone, but now consumer spending is being held back by shortages? If I’m interpreting it correctly, this metric is very suggestive of inflationary conditions.

I'd be careful about any "checkable deposits" series, since they changed banking regulations early in the pandemic which ended up moving a lot of savings accounts in with checking accounts. Here's a another series that shouldn't have been affected by this:

https://fred.stlouisfed.org/series/DABSHNO

It shows basically the same thing: a dramatic upswing of trillions of dollars, but it's not like households have 4x more money than ever.