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

[ChpBstrd]

October's CPI and Core CPI were incredibly tame, and the Nasdaq is up 5.8% this morning, doing some serious damage to my short ETF positions. Adding fuel to the burn-up was Philly president Patrick Harker's comment that he, a non-voting FOMC member, would like to see a rate hiking pause at 4% or 4.5%. Perhaps the FOMC is using comments by non-voting members to advance signal their intentions?
https://finance.yahoo.com/news/feds-harker-says-favors-possible-144936041.html

I've heard that before - but that's the Taylor Rule?  Fed Chair Powell claimed he is not following it, and is instead watching the data.  What if the FFR always exceeded inflation because the lags were so long, FFR increases were made after they were no longer needed?  The historical examples always end in recession, I believe, which also suggests too many rate hikes were made.

The Fed giving forward guidance really is different this time - it hasn't been done like that before.  The market takes advantage of information, so it has priced in the Fed guidance - and each time the Fed has followed through.  The markets are not reacting to Fed actions, but to Fed guidance.  That in turn could shrink the lag between rate hikes and economic tightening.

Powell famously does not trust forecasts, and makes decisions only after they are supported after a long series of data. Philosophically, he believes the Fed has errored or overreacted in the past by responding to short term trends and faulty forecasts instead of a long term series of actual data. By looking at a longer series of data, he believes he can reduce the whiplash that has led to inflationary or recessionary events in the past, such as the post-1974 return of inflation or the 2007-09 financial crisis. However, this same policy stance is what led the Fed to let inflation "run hot" for a year before doing anything about it - a policy which was communicated at Jackson Hole in August 2020, and which turned out to be a mistake.

One of the things I'm looking for in the comments is an indication that (a) the FOMC changed this policy stance and will now make decisions based on shorter-term trends, or (b) the FOMC will use a different criteria for making decisions about when to taper down the rate hikes than it used for when to raise rates. So far, Powell seems steadfast in his belief that trends shorter than maybe 6 months should not be considered actionable. That's plenty of time for the Fed to overshoot whatever the "neutral" rate is, even at 0.5% or 0.25% rate hikes. I.e. three 0.5% hikes plus three 0.25% hikes would put us at 6.25%.

The Fed's commentary and policy notes have been fairly accurate predictors of what they will do next, even if the dot plot and predicted EoY interest rates have been consistent misses. We were told in advance about the methodological shift to longer-term data trends. We were told in advance about letting inflation "run hot" for a while to make up for past disinflation. We were told with about 6 months lead time about the end of QE and the first rate hikes. For the past 2.5 years one could have listened to policy statements and effectively predicted FOMC actions, as long as one ignored their specific inflation and interest rate predictions!

They can't predict inflation or future interest rates, but they will tell you exactly what they're going to do and typically with a large lead time. So when Powell says "we have a ways to go" with more rate hikes, I am more skeptical than all the people buying in reaction to the low October CPI and piling into futures predicting a 0.5% rate hike in December.

Your question about whether Powell believes in the Taylor Rule is an interesting one. I assumed he does know about the Taylor Rule, can see the history of how the FFR must usually exceed CPI before Core CPI falls, but cannot tell us rates are going to 6-7% for fear of creating a sudden crisis. Still, the Fed is telling us what they're going to do; it's literally published on their website and has been for 4 years. I assume "long ways to go" comment, paired with comments about how far rates have already risen in 2022 (375bp), is suggestive of another 200-300 basis points in hikes. But maybe I'm wrong.

Let's explore the alternate possibility you bring up: Powell, a non-economist, doesn't trust the Taylor Model, and is committed to mechanistically reacting to multi-month data trends as they arrive. The FOMC will taper or stop the rate hikes when it sees, let's say, a 6-month trend of declining inflation PLUS recessionary signals which indicate the 2% goal is immanently approaching. This would be consistent with Powell's comments about looking at a broad range of data, presumably to create real-time narratives about where we are in the business cycle. By this rationale, we've already seen a multi-month downtrend in inflation since June 2022 and advance recession signals are flashing red, including the NFCI and yield curves, both of which were directly referenced in Powell's last comments. These signals could be interpreted by the FOMC as a sign they've raised rates sufficiently to create a small recession that will do the rest of the work.

Maybe the FOMC still doesn't trust economists' models and forecasts, but they do trust recession indicators and are using these as a "taper signal", in conjunction with a downward trend in inflation? I'd be interested in more information to support this conclusion, but so far I am reluctant to bet on it when Powell told me directly he has a lot more rate hikes in mind.

I do suspect the FOMC will approach the peak of its rate hikes by dialing down to 0.5% and 0.25% hikes and the markets will briefly celebrate. However, hikes of these magnitudes could continue for the first 6 meetings of 2023 and still leave us with a terminal FFR of 6-7%.

Earlier this year I firmly believed in a severe recession.  Historical data shows tightening (QT or equivalent, rate hikes) of this magnitude leads to recession.  We've had the longest bull market in history - defying the business cycle's alternating bull and bear markets.  So there were reasons I believed things would get much worse.

But right now I'm no longer sure.  That's why my biggest holding is the S&P 500, because I'd like to wait and see.  Paul Krugman believes inflation has already peaked, but he might be overly focused on housing (which, admittedly, is a big part of the ecomomy).  Larry Summers expected core PCE to rise before the last CPI report, and it did, reinforcing my belief he's studying the data carefully (he also mentions taking median inflation, middle half inflation, and numerous other measures).

I believe the market's median prediction is a mild recession.  If you have data and experts to dispute that consensus, you can profit off a crash by going to cash or buying put options.  Both of my primary predictions have already come true - yields rose significantly, and recession risk is priced in.  That's why weeks ago I switched to the S&P 500, and am currently waiting it out.

There is a case to be made for re-entering the market prior to "the bottom" in order not to miss the bottom, particularly if you are hedging. The actual bottom will be or was a point where the economic data look gloomiest and the rationale (read: our likelihood) for diving into the stock market is at its lowest. If you've been right to sit out a multi-month period of rising rates and stock declines, you must cash in your winnings at some point or else watch the market eventually run away without you.

I considered this point too, but the thing that gives me pause is a chart of the S&P500 with recessions shaded. Most of the drop in stock valuations occurs during the recession, not before it, and I'm pretty sure we are not in a recession right now (see initial claims, unemployment rate, durable goods, GDPNow, etc).

I've seen some charts which show gains are possible between the recession start date and the recession end date. For example: https://invesbrain.com/sp-500-performance-before-during-and-after-recessions/

But typically when you drill down you'll find double-digit losses in the middle of these recessions followed by a V-shaped recovery also occurring during the recession. If you measure from the recession start date to the recession end date, that often obscures dramatic collapses in stock values that occurred mid-recession and only reversed as rates were cut. Such charts tell me IF a recession is coming, the stock market can be expected to go lower than it was pre-recession, even if we exit the recession at higher prices than we have today. 

Here's the case for there not even being a recession (get around the paywall with a free account):
https://www.ft.com/content/c728b7f0-b4dc-46d7-8089-36734a266e03

The case for the unexpected scenario — no recession in the coming months — would start with inflation declining rapidly. That would allow the Fed to back off from further tightening. Just when the consensus has come to accept that inflation will be higher for longer, and not “transitory” as previously assumed, the easing of supply chain bottlenecks could lower inflation faster than expected.

The signs include cargo shipping prices plummeting, delays at ports shortening and the Fed’s “supply chain pressure index” coming down sharply. China’s economy is in a funk and is exporting slower inflation to the rest of the world. Goods inflation is decelerating with prices for everything from used cars to energy now in decline.
.......
Lower inflation would further boost the confidence of American consumers, who are in unusually strong financial shape. Bank deposits swelled during the pandemic, and $2.5tn of that cash is still in the banks. Personal net worth is still about $25tn higher than before the pandemic. The debts that imploded in the Great Recession of 2007-2009 have largely vanished: today nearly 70 per cent of home buyers have FICO credit scores in the top tier — over 760 — compared with 20 per cent before the crisis.

[ChpBstrd]

Does anyone have a mental model that explains the low October CPI data (0.3% Core CPI)? I can imagine a few scenarios:

--Noise

--Statistical Error: I have my doubts that the return to in-person CPI data collection is seamless. This goes particularly for used cars and apparel, which I allege may be distorted in the transition from largely online data collection to largely in person data collection. I can imagine how this transition could, in aggregate, skew these indexes. If this is the case, core PCE could depart from the core CPI significantly.

--Krugman's narrative is correct. Inflation has peaked, dragging the brakes with QT and rate hikes did its job, and inflation will continue a downward trajectory. The Taylor rule is no longer useful due to new tools like QT and forward guidance.

Other ideas? I am in the noise/statistical error camp because I am having a hard time untying inflation and employment in my brain. How can things be turning deflationary when the labor market is this tight?

I'm in the noise camp.  CPI has been crazy hot all year, so maybe it isn't quite so hot for one month.  That doesn't necessarily mean that the Fed's work is done or is even that it is directly responsible for inflation easing.  Consumers could just be hitting a wall.  Longer term, if the Fed eases off the inflation battle too soon, we are likely to be dealing with elevated inflation for longer.  We are still seeing real estate hold its value and change hands quickly all around us, so I don't expect inflation to collapse in the coming months.  That, in my mind, would be the most obvious signal that the increased borrowing rates are having a real effect.

There is also the optimistic possibility that QT is somehow responsible, but I have no data for if that would work practically.

I'm also in the noise camp for now, but remain open to the possibility of a shift. I don't think we'll hear Powell say something other than "inflation remains far too high" just because of one month's data. Recall my earlier note about how volatile inflation metrics were in the 1970s, and how monthly data were misleading.

I am also skeptical about the odds of a 0.5% rate hike in December, which the futures market now says is an >85% probability. For a FOMC that is lacking credibility, fearful of inflationary expectations setting in, and still facing very negative real rates, another 0.75% hike would be the perfect move. Powell didn't repeatedly say "we have a long ways to go" only to taper at the very next meeting, but even if the Fed did taper, a series of 0.5% and 0.25% hikes will still bring us to an FFR over 6% by summer.

I don't know what to think about Paul Krugman's hypothesis that "underlying" inflation is actually 3-4% because housing cost decreases and relatively slow wage growth are not reflected in the data. I do not think Krugman would have much luck persuading a data-reactive individual like Jerome Powell, based on a forecast focused on two relatively short-term anecdotes, wages and rents. One could just as easily frame a counter-narrative that rents, equivalent rents, and wages are "sticky" elements of CPI, and have not yet caught up with energy, consumer staples, consumer discretionaries, etc.

Regarding QT, Powell was asked about the efficacy of that last spring. He literally threw his hands in the air and declared it an intractable problem. He finally answered that the QT campaign might amount to the equivalent of a 0.25% rate hike. I think it has a bigger effect than a 0.25% hike, but there's no working economic model that I'm aware of that translates QE/QT to a change in inflation.

[EscapeVelocity2020]

Does anyone have a mental model that explains the low October CPI data (0.3% Core CPI)? I can imagine a few scenarios:

--Noise

--Statistical Error: I have my doubts that the return to in-person CPI data collection is seamless. This goes particularly for used cars and apparel, which I allege may be distorted in the transition from largely online data collection to largely in person data collection. I can imagine how this transition could, in aggregate, skew these indexes. If this is the case, core PCE could depart from the core CPI significantly.

--Krugman's narrative is correct. Inflation has peaked, dragging the brakes with QT and rate hikes did its job, and inflation will continue a downward trajectory. The Taylor rule is no longer useful due to new tools like QT and forward guidance.

Other ideas? I am in the noise/statistical error camp because I am having a hard time untying inflation and employment in my brain. How can things be turning deflationary when the labor market is this tight?

I'm in the noise camp.  CPI has been crazy hot all year, so maybe it isn't quite so hot for one month.  That doesn't necessarily mean that the Fed's work is done or is even that it is directly responsible for inflation easing.  Consumers could just be hitting a wall.  Longer term, if the Fed eases off the inflation battle too soon, we are likely to be dealing with elevated inflation for longer.  We are still seeing real estate hold its value and change hands quickly all around us, so I don't expect inflation to collapse in the coming months.  That, in my mind, would be the most obvious signal that the increased borrowing rates are having a real effect.

There is also the optimistic possibility that QT is somehow responsible, but I have no data for if that would work practically.

I'm also in the noise camp for now, but remain open to the possibility of a shift. I don't think we'll hear Powell say something other than "inflation remains far too high" just because of one month's data. Recall my earlier note about how volatile inflation metrics were in the 1970s, and how monthly data were misleading.

I am also skeptical about the odds of a 0.5% rate hike in December, which the futures market now says is an >85% probability. For a FOMC that is lacking credibility, fearful of inflationary expectations setting in, and still facing very negative real rates, another 0.75% hike would be the perfect move. Powell didn't repeatedly say "we have a long ways to go" only to taper at the very next meeting, but even if the Fed did taper, a series of 0.5% and 0.25% hikes will still bring us to an FFR over 6% by summer.

I don't know what to think about Paul Krugman's hypothesis that "underlying" inflation is actually 3-4% because housing cost decreases and relatively slow wage growth are not reflected in the data. I do not think Krugman would have much luck persuading a data-reactive individual like Jerome Powell, based on a forecast focused on two relatively short-term anecdotes, wages and rents. One could just as easily frame a counter-narrative that rents, equivalent rents, and wages are "sticky" elements of CPI, and have not yet caught up with energy, consumer staples, consumer discretionaries, etc.

Regarding QT, Powell was asked about the efficacy of that last spring. He literally threw his hands in the air and declared it an intractable problem. He finally answered that the QT campaign might amount to the equivalent of a 0.25% rate hike. I think it has a bigger effect than a 0.25% hike, but there's no working economic model that I'm aware of that translates QE/QT to a change in inflation.

For all anyone knows, QT could be doing the heavy lifting, although individuals feel the rate hikes more viscerally.  But QT typically tanks the market and that is not happening right now for sure...

[PDXTabs]

Does anyone have a mental model that explains the low October CPI data (0.3% Core CPI)? I can imagine a few scenarios:

--Noise

--Statistical Error: I have my doubts that the return to in-person CPI data collection is seamless. This goes particularly for used cars and apparel, which I allege may be distorted in the transition from largely online data collection to largely in person data collection. I can imagine how this transition could, in aggregate, skew these indexes. If this is the case, core PCE could depart from the core CPI significantly.

--Krugman's narrative is correct. Inflation has peaked, dragging the brakes with QT and rate hikes did its job, and inflation will continue a downward trajectory. The Taylor rule is no longer useful due to new tools like QT and forward guidance.

Other ideas? I am in the noise/statistical error camp because I am having a hard time untying inflation and employment in my brain. How can things be turning deflationary when the labor market is this tight?

I'm in the noise camp.  CPI has been crazy hot all year, so maybe it isn't quite so hot for one month.  That doesn't necessarily mean that the Fed's work is done or is even that it is directly responsible for inflation easing.  Consumers could just be hitting a wall.  Longer term, if the Fed eases off the inflation battle too soon, we are likely to be dealing with elevated inflation for longer.  We are still seeing real estate hold its value and change hands quickly all around us, so I don't expect inflation to collapse in the coming months.  That, in my mind, would be the most obvious signal that the increased borrowing rates are having a real effect.

There is also the optimistic possibility that QT is somehow responsible, but I have no data for if that would work practically.

I'm also in the noise camp for now, but remain open to the possibility of a shift. I don't think we'll hear Powell say something other than "inflation remains far too high" just because of one month's data. Recall my earlier note about how volatile inflation metrics were in the 1970s, and how monthly data were misleading.

I am also skeptical about the odds of a 0.5% rate hike in December, which the futures market now says is an >85% probability. For a FOMC that is lacking credibility, fearful of inflationary expectations setting in, and still facing very negative real rates, another 0.75% hike would be the perfect move. Powell didn't repeatedly say "we have a long ways to go" only to taper at the very next meeting, but even if the Fed did taper, a series of 0.5% and 0.25% hikes will still bring us to an FFR over 6% by summer.

I don't know what to think about Paul Krugman's hypothesis that "underlying" inflation is actually 3-4% because housing cost decreases and relatively slow wage growth are not reflected in the data. I do not think Krugman would have much luck persuading a data-reactive individual like Jerome Powell, based on a forecast focused on two relatively short-term anecdotes, wages and rents. One could just as easily frame a counter-narrative that rents, equivalent rents, and wages are "sticky" elements of CPI, and have not yet caught up with energy, consumer staples, consumer discretionaries, etc.

Regarding QT, Powell was asked about the efficacy of that last spring. He literally threw his hands in the air and declared it an intractable problem. He finally answered that the QT campaign might amount to the equivalent of a 0.25% rate hike. I think it has a bigger effect than a 0.25% hike, but there's no working economic model that I'm aware of that translates QE/QT to a change in inflation.

For all anyone knows, QT could be doing the heavy lifting, although individuals feel the rate hikes more viscerally.  But QT typically tanks the market and that is not happening right now for sure...

As far as mortgage rates go I think that individuals do feel QT.

[MustacheAndaHalf]

October's CPI and Core CPI were incredibly tame, and the Nasdaq is up 5.8% this morning, doing some serious damage to my short ETF positions. Adding fuel to the burn-up was Philly president Patrick Harker's comment that he, a non-voting FOMC member, would like to see a rate hiking pause at 4% or 4.5%. Perhaps the FOMC is using comments by non-voting members to advance signal their intentions?
https://finance.yahoo.com/news/feds-harker-says-favors-possible-144936041.html

Harker becomes a voting FOMC member in about 2.5 months.

Earlier this year I firmly believed in a severe recession.  Historical data shows tightening (QT or equivalent, rate hikes) of this magnitude leads to recession.  We've had the longest bull market in history - defying the business cycle's alternating bull and bear markets.  So there were reasons I believed things would get much worse.

But right now I'm no longer sure.  That's why my biggest holding is the S&P 500, because I'd like to wait and see.  Paul Krugman believes inflation has already peaked, but he might be overly focused on housing (which, admittedly, is a big part of the ecomomy).  Larry Summers expected core PCE to rise before the last CPI report, and it did, reinforcing my belief he's studying the data carefully (he also mentions taking median inflation, middle half inflation, and numerous other measures).

I believe the market's median prediction is a mild recession.  If you have data and experts to dispute that consensus, you can profit off a crash by going to cash or buying put options.  Both of my primary predictions have already come true - yields rose significantly, and recession risk is priced in.  That's why weeks ago I switched to the S&P 500, and am currently waiting it out.

There is a case to be made for re-entering the market prior to "the bottom" in order not to miss the bottom, particularly if you are hedging. The actual bottom will be or was a point where the economic data look gloomiest and the rationale (read: our likelihood) for diving into the stock market is at its lowest. If you've been right to sit out a multi-month period of rising rates and stock declines, you must cash in your winnings at some point or else watch the market eventually run away without you.

I considered this point too, but the thing that gives me pause is a chart of the S&P500 with recessions shaded. Most of the drop in stock valuations occurs during the recession, not before it, and I'm pretty sure we are not in a recession right now (see initial claims, unemployment rate, durable goods, GDPNow, etc).

Recessions are announced months after they occur.  You can look at the past three recessions with lags of 2-3 months, or go back further and see lags of 3-6 months.  If you wait for a recession before buying, the market will probably be a few months into a recovery by then - and recoveries can happen very fast.
https://www.dimensional.com/us-en/insights/are-we-headed-for-a-recession

I found a June 9 2020 article by CNBC relaying that a recession had been declared.  I'm not saying we will see a replay.  But on June 9 2020, the S&P 500's year to date performance was +0%.  Someone who bought when the 2020 recession was declared had already missed the entire recovery.  While unusual, that provides a dramatic example of a recovery that happened quickly.
https://www.cnbc.com/2020/06/09/us-officially-in-a-recession-but-its-different-than-2008.html

[ChpBstrd]

Earlier this year I firmly believed in a severe recession.  Historical data shows tightening (QT or equivalent, rate hikes) of this magnitude leads to recession.  We've had the longest bull market in history - defying the business cycle's alternating bull and bear markets.  So there were reasons I believed things would get much worse.

But right now I'm no longer sure.  That's why my biggest holding is the S&P 500, because I'd like to wait and see.  Paul Krugman believes inflation has already peaked, but he might be overly focused on housing (which, admittedly, is a big part of the ecomomy).  Larry Summers expected core PCE to rise before the last CPI report, and it did, reinforcing my belief he's studying the data carefully (he also mentions taking median inflation, middle half inflation, and numerous other measures).

I believe the market's median prediction is a mild recession.  If you have data and experts to dispute that consensus, you can profit off a crash by going to cash or buying put options.  Both of my primary predictions have already come true - yields rose significantly, and recession risk is priced in.  That's why weeks ago I switched to the S&P 500, and am currently waiting it out.

There is a case to be made for re-entering the market prior to "the bottom" in order not to miss the bottom, particularly if you are hedging. The actual bottom will be or was a point where the economic data look gloomiest and the rationale (read: our likelihood) for diving into the stock market is at its lowest. If you've been right to sit out a multi-month period of rising rates and stock declines, you must cash in your winnings at some point or else watch the market eventually run away without you.

I considered this point too, but the thing that gives me pause is a chart of the S&P500 with recessions shaded. Most of the drop in stock valuations occurs during the recession, not before it, and I'm pretty sure we are not in a recession right now (see initial claims, unemployment rate, durable goods, GDPNow, etc).

Recessions are announced months after they occur.  You can look at the past three recessions with lags of 2-3 months, or go back further and see lags of 3-6 months.  If you wait for a recession before buying, the market will probably be a few months into a recovery by then - and recoveries can happen very fast.
https://www.dimensional.com/us-en/insights/are-we-headed-for-a-recession

I found a June 9 2020 article by CNBC relaying that a recession had been declared.  I'm not saying we will see a replay.  But on June 9 2020, the S&P 500's year to date performance was +0%.  Someone who bought when the 2020 recession was declared had already missed the entire recovery.  While unusual, that provides a dramatic example of a recovery that happened quickly.
https://www.cnbc.com/2020/06/09/us-officially-in-a-recession-but-its-different-than-2008.html

Recessions are not merely statistical events though. They are something that is felt, especially in the unemployment rate. A recession could start at an unemployment rate of 3.5%-3.7% like the last 4 months and go up from there, but I do not think a period of time could count as a recession if unemployment stayed that low. It wouldn't be a broad-based decline in economic activity if somebody didn't lose their job, or if retail sales didn't decline. You'll know it when we're in recession. Look at the contemporaneous data one could have witnessed in real time in these data sets:

A fall in retail sales is an indicator with few/no false positives:

Look for a 2%+ increase in unemployment:

Look for high-yield spreads over 7%:

Look for a significant drop in industrial production:


We don't have to time the beginning of recession, which would be market timing. I'll be watching for data that confirms we're in a recession, because I think it's when we're deep into the recession where the risk/reward ratio is probably highest. Once recession is obvious, it's time to buy.

All we have to do is look at contemporaneous data like initial claims, total industrial production, and high-yield vs. treasury spreads to figure out if we are currently deep in recession. These indicators may not be great at predicting recession, but they are good at identifying recession once you are already there. We can also look around us and see layoffs, foreclosures, and the disappearance of all those "now hiring" signs currently posted all about. The buy signal will be all these signals put together. It'll be almost unmistakable, as it was in 2008 and 2001.

I think the odds of avoiding recession are between 0% and 1%, so if past patterns hold, stocks will be getting significantly cheaper during that recession.

[ChpBstrd]

Well hasn't it been a crazy two weeks?

October
CPI: +0.4% monthly gain, 7.7% TTM
Core CPI: +0.3% monthly gain, 6.3% TTM
PPI: +0.2% monthly gain, 8% TTM
Core PPI: +0.2% monthly gain, 5.4% TTM

Stocks and bonds are up on the news, because investors are hoping this means a lower terminal interest rate and/or a milder recession. I've seen articles with pundits talking about a 0.5% rate hike in December maybe being the last. Also, the 10y treasury yield has dropped from 4.22% to 3.67% in just 9 days, and some of the bonds I picked up are now up nearly 10%. Mortgage rates are falling.

However the FFR futures market is still assuming a 5.00-5.25% FFR by May.
https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html?redirect=/trading/interest-rates/countdown-to-fomc.html

The specific scenario currently envisioned by most FFR futures market participants is:
Dec: 0.5% hike to 4.5%
Feb: 0.5% hike to 5%
Mar: pause
May: 0.25% hike to 5.25%...
Sept: 0.25% rate cut to 5%...
Dec '23: 0.25% rate cut to 4.75%

So I have 2 questions:

1) Is the pattern of falling CPI and PPI we've seen since June possible if, as the Taylor Rule suggests, policy is still stimulative and the inflationary cycle isn't over? How long do we dismiss the data as noise instead of accepting a change in the trend? Are there any historical instances like this, where the trend was still inflationary despite a 4-mo trend of falling CPI + PPI?

2) Are asset markets currently priced for a 5.25% terminal rate, which the futures market sees as likely, or will asset valuations fall further as those hikes arrive?

---------------
Four Months of Falling CPI & PPI Don't Mean The Trend Is Over
For an answer to the first question, I returned to a combined chart of CPI and PPI during the 1970s and early 80s. A four-month trend of net declining CPI and PPI, at the same time, and within a couple years of an increase in inflation, would prove that today's trend is not a reliable signal that inflation is dead.

A minimum four-month net decline in both measures began in 3Q1967, 4Q1973, 1Q1974, 3Q1974, 3Q1975, 2Q1977, 2Q1978, 2Q1980, and 2Q1981. Some of these periods of declining CPI and PPI lasted well over 4 months. The historical answer to the question is a DEFINITE NO. Four months of falling inflation do not mean the trend is over. Four-month stretches of falling inflation are actually common during inflationary or stagflationary episodes.
https://fred.stlouisfed.org/graph/?g=WvPs

----------------
Assets Prices Are Within Reason If The FFR Will Peak At 5.25%
For an answer to the 2nd question, I looked at the S&P500's earnings ttm yield (1/20.5= 4.88%), the S&P500's forward earnings yield (1/17.2= 5.81%), and the 10y treasury yield (3.77% today). AAA corporate bonds with 10-20 years duration are yielding around 4.56%, and dropping down to A rating gets you 5.9%.

The forward EY on the S&P 500 is based on expected earnings growth that doesn't factor in the possibility probability of a recession. It's not a recession if earnings go up 16% in 2023 as compared to 2022! Throw the forward PE in the trash right now.

With the 10y/2y yield curve inverted to -0.68%, the 1mo/10y yield curve inverted (!), after rate hikes at a speed not seen since the early 1980's and which have never NOT led to a recession, with the NFCI trending toward zero, and with consumer confidence at 25-year lows, all signs say earnings could go way down in 2023. Stocks should be priced to reflect these factors, but they are not.
https://www.yardeni.com/pub/stockmktperatio.pdf
https://home.treasury.gov/resource-center/data-chart-center/interest-rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value_month=202211
https://tradingeconomics.com/united-states/consumer-confidence

The tricky part is accounting for an expected overnight/10y yield curve inversion (the 10y yield sets the risk free rate that we add a risk premium to in order to arrive at a fair earnings yield). Back in September, I noted how the historical data suggest inversion could easily be -1.5% or so, though there is no fixed relationship between these factors: https://forum.mrmoneymustache.com/investor-alley/inflation-interest-rates-share-your-data-sources-models-and-assumptions/msg3059511/#msg3059511

This is why the 10y yield has been falling even though we all know we're probably in for 100-150 basis points of additional hikes. The 10y yield could stick around 4% even as the FFR rose to 5.25% or 5.5% or 6%. When thinking long-term, investors have to anticipate future rate cuts, and that's what they do when recession is expected within 12 months, as it is today. Yields on long-duration corporate bonds and earnings yields on stocks would also lag short-duration rates like the FFR, because these are long-duration assets and you can't retire on the FFR.

So my answer is YES, long-duration assets may be priced for the expectation of a 5% to 5.25% peak FFR.
----------------
Bullard Offers A Model
Hawkish FOMC member James Bullard (who doesn't get a vote in '23 or '24*) presented a direct application of the Taylor Rule in a speech today, dousing a bit of water on the latest rally. His slides should be mandatory reading for anyone invested in markets or interested in inflation / interest rates. The key slide image is attached below.

Bullard shows how the Taylor Rule specifies rates should be about 5.25%-7% right now in order to be restrictive. One caveat is that rates can only rise so fast, and we don't know where inflation will be when rates hit 5.25% six months for so from now. If the trend of falling inflation continues, the intersection point between CPI and FFR will happen close to 5.25%. A spike in commodities or wage growth could derail that narrative quickly though. In the 1970s, episodes when the FFR<CPI were followed by an inflation boom that sometimes came over a year or more later. Similarly, the 2021 inflation boom materialized a year after stimulus started. The theme is to think in terms of years, not months, because inflation can change course slowly.

https://www.stlouisfed.org/-/media/project/frbstl/stlouisfed/files/pdfs/bullard/remarks/2022/nov/bullard-louisville-17-nov-2022.pdf?sc_lang=en&hash=4725A924300B1A6777E788822AF33277
-----------------------

Conclusions:

1) The trade idea of betting against long-duration assets because markets had not yet accepted the inevitability of a 5%+ FFR is over. Bullard's hawkish prescription calls for a minimum 5.25% FFR, and the markets are priced for this, so any potential overshoot beyond 5.25% is speculative. It's fair to say the markets have come over to Bullard's side, even if they are pricing in the best case scenario Bullard can calculate.

2) It is unclear if corporate bonds will go much lower, so it's time to start DCA'ing into an AA you can live with during the coming recession. Sell stocks to arrive at that AA if you need to, because 20.5X earnings is more than fair, given these conditions. There remains a risk that inflation continues to build, and rates have to rise further. The Taylor Rule and economic history suggest they will. You'd rather eat that risk while earning 5-8% than in stocks though. I also like bonds because if this time is different, and inflation plummets despite the FFR<CPI, you still participate in significant appreciation.

3) The new trade is about having plenty of capital available in 2023 or 2024 to take advantage when stocks go on fire sale during the recession. The market's direction will be unclear for at least the next 6 mos. There's a very good case for 9-month or 1 year treasury bonds right now, because you could watch the coming chaos from a safe place while earning 4.6% and then parachute into a possibly panicking stock market upon maturity.

4) The current rally, driven by hope that rates might peak at 4.75% or 4.5%, is a classic bull trap. The FOMC might go with a 50 basis point hike in December, but they'd lose all credibility if they didn't follow that with another 50bp in Feb. after saying "we have a long ways to go" just weeks ago. A taper down to a 25bp hike in March is the best case scenario, and would have to be accompanied by horrible things happening in the economy. That best case scenario wouldn't mean there won't be another 25bp in May either. The FOMC is reviewing the history of the 1970s and have at least as good data as we have. They are no doubt aware of the false dawns that doomed Arthur Burns' efforts and have expressed determined language to that effect. Rates won't be cut in 2023 unless we have a disinflationary spiral like 2008.

*If Bullard would like to be Chairperson in 3 years, now is an excellent time to leave mainstream-to-hawkish advice. If in 3y people are still concerned about inflation, Bullard can show how he tried to tell them to be more aggressive, or tried to warn everybody about what had to happen, and he can maintain his innocence regarding any perceived policy mistakes that occurred in '23 or '24. If inflation goes away, nobody will care about these slides demonstrating an academic theory, but if it gets worse he will be a prophet. This is Bullard's logical path to bypass Vice Chairperson Lael Brainard, the most dovish member of the FOMC. She is next in line when Powell's term runs out and Biden almost nominated her instead of Powell. Yet if inflation remains a problem Brainard's perspective will look out of date in 2025. The timing couldn't be better for Bullard to run this play. https://www.itcmarkets.com/hawk-dove-cheat-sheet-2/

[PDXTabs]

1) The trade idea of betting against long-duration assets because markets had not yet accepted the inevitability of a 5%+ FFR is over. Bullard's hawkish prescription calls for a minimum 5.25% FFR, and the markets are priced for this, so any potential overshoot beyond 5.25% is speculative. It's fair to say the markets have come over to Bullard's side, even if they are pricing in the best case scenario Bullard can calculate.

I concur. An excellent analysis as usual.

[ChpBstrd]

"Team Transitory" is now "Team Tighter Than U Think".

The doves are alive and well at the Federal Reserve, but they don't make headlines so you have to go looking for their thoughts. Here's a succinct statement of their case from Nov. 7:
https://www.frbsf.org/economic-research/publications/economic-letter/2022/november/monetary-policy-stance-is-tighter-than-federal-funds-rate/?utm_source=mailchimp&utm_medium=email&utm_campaign=economic-letter

The TL;DR is:

1) After 2008, the Fed started using QE/QT and forward guidance as policy tools. The forward guidance, as everyone recalls, kept predicting a rise of inflation that never materialized. The QE and forward guidance netted out to a tighter monetary policy than the 0% lower bound on the FFR by itself would suggest. Evidence for this claim is the low inflation between 2009 and 2020 despite low interest rates.
2) Research done in 2013-2018 tried to establish a "proxy funds rate" to estimate what FFR would have caused the observed effects without QE/QT or forward guidance.
3) The authors built upon this to statistically create a proxy rate that incorporates treasury rates, mortgage rates, borrowing spreads, etc. Their exact method is not described here.
4) Their output is that the "proxy funds rate" was around 5.25% at the end of September 2022, and rising fast.

I applaud these efforts to try quantifying the effects of QE/QT and forward guidance, because I would like to see a world where QE/QT reduces the necessity for rate volatility around recessions and eventually becomes the main policy tool. Also I was highly dissatisfied with Powell's dismissal last spring of QT as a major way to solve the inflation problem. He waved his hands around in frustration and called it maybe the equivalent of a quarter point rate hike. And that was after his own pandemic response QE program co-occurred with a major outbreak of inflation. There's a case to be made that we should be watching QE/QT as much or more than the interest rate, because adding and removing cash from the economy is a very straightforward way to affect prices. M2 is falling significantly now, which is highly unusual, and somewhat coinciding with the falling inflation trend.

Of course, I have comments about each of the points above:

1) The low inflation between 2009 and 2020 probably had lots of causes other than federal intervention, such as demographics, post-GFC psychology, the US threatening to default on its national debt a couple of times, fast-rising wealth inequality, European austerity plans, and a rapid rise in the trade deficit + national debt which sidelined lots of dollars from the real economy. Do the models account for any of these factors? Also, the Fed's forward guidance should have lost credibility after the first few quarters, when they couldn't predict inflation or even their own behavior a few months out. Pundit guidance, which was available before 2008, might be just as good. Was forward guidance really a factor preventing consumers from spending or spurring companies to build overcapacity?

2) How many observations was the model based on? A single decade between 2009 and 2020 when the old models of inflation stopped working?

3) The entire claim is only as good as a detailed examination of the rationale behind each and every statistical and data decision they made. The letter is written in a way that makes it sound as if they assigned the outcomes to the presumed causes that fit into their model: rates, QE/QT, and forward guidance. That's sort of like putting the effects before the causes which you already know, in order to prove the causes, but hey we're talking economics. For an illustration of how the government's models are spitting out wildly different numbers depending on data and model assumptions, see: https://www.clevelandfed.org/indicators-and-data/simple-monetary-policy-rules

That said... we've had a 4 month falling inflation trend which seems to contradict expectations based on the Taylor Rule, and these researchers are offering an explanation for that change in trend. A 5.25% proxy funds rate might be close enough to core CPI / core PCE that it is bending the inflation curve downward as we speak. If the proxy funds rate is now more like 6%, we're close to par with Core CPI and set to exceed it in December. This is where the pause talk is coming from.

If the researchers are right, peak interest rates might be right around the corner - perhaps by February. Anyone buying assets (e.g. bonds) with longer durations than February has to be thinking today's rates might be as good as it gets. The next two rate hikes could be swallowed by a widening yield curve and not even effect the long end. To these investors, the risk of being left behind by the bond market when we start thinking about rate cuts again has to offset the risk of rates going higher than the minimum forecast. When those risks offset one another, they buy.

Nonetheless, Powell is one of the most dovish FOMC members, and I haven't heard him make a peep about a "proxy funds rate". As best I can tell, he and a few other FOMC members remain in the camp that a series of data points should be the only thing that can change a policy direction, not an economic model and definitely not a forecast. Y'all correct me if I'm wrong, but I don't see Powell talking this way in the press conferences other than that slip in May equating QT to rates. This "proxy rates" theory may be considered on the fringe by the Fed, but the market seems to believe it over the Taylor Rule.

Of course, the interesting thing Powell could do to placate the doves would be to wind down QT well before winding down interest rates, and then see what happens. Maybe the effect is >0.25%; maybe it's much, much bigger. Holding rates and cutting QT could be an interesting experiment.

[BicycleB]

Of course, the interesting thing Powell could do to placate the doves would be to wind down QT well before winding down interest rates, and then see what happens. Maybe the effect is >0.25%; maybe it's much, much bigger. Holding rates and cutting QT could be an interesting experiment.

If they did this and inflation rose, would that suggest QT is more powerful than Powell thought?

To put this another way: If QT is more powerful than Powell thought, and the Fed implemented the quoted policy, should we expect inflation to rise?

[ChpBstrd]

Of course, the interesting thing Powell could do to placate the doves would be to wind down QT well before winding down interest rates, and then see what happens. Maybe the effect is >0.25%; maybe it's much, much bigger. Holding rates and cutting QT could be an interesting experiment.

If they did this and inflation rose, would that suggest QT is more powerful than Powell thought?

To put this another way: If QT is more powerful than Powell thought, and the Fed implemented the quoted policy, should we expect inflation to rise?

Yea, if the effect of QT is more like an additional 200 basis points in interest rates (as opposed to Powell’s estimate of 0.25%), then cessation of the policy would be a major net loosening. This is essentially a consequence of the dovish argument. It implies the proxy Fed funds rate was deeply negative in 2020-early 2022 during QE, and that it is deeply positive now with QT.

On the other hand, maybe QT doesn’t really affect supply or demand or inflation in the real economy, and only interest rates matter. The Fed is, after all, just passively not replacing bonds and mortgages as they mature off the balance sheet. It would be an interesting experiment to stop one intervention and keep the other going.

[blue_green_sparks]

Out of curiosity, I used the 10-yr-treas forecast here-> https://econforecasting.com/forecast-t10y to see a forecast of what would happen to our fixed income if I just bought 10-year, t-bonds as my current fixed matures out to 2026. Tracking for about a month so far, it is looking less rosy all the time. Right now, my allocation of bonds, CD annuities and CDs yields around $38K.
-------------------------------
10/22/2022 $57,994.96
10/25/2022 $56,734.54
10/26/2022 $54,310.41
10/26/2022 $52,693.84
10/31/2022 $53,001.31
11/4/2022   $56,837.71
11/6/2022   $49,773.41
11/8/2022   $50,082.29
11/11/2022 $44,882.33
11/13/2022 $45,043.22
11/17/2022 $40,483.46
11/20/2022 $41,354.96

[ChpBstrd]

@blue_green_sparks Could you please hold my hand and give me a 5 year old's explanation of how the above calculation was performed? My understanding is that you're saying $X would be your annual income from a portfolio if you had invested in 10y treasuries on each of the various dates, but the amount of income does not seem to correlate with 10y yields available on those dates. So I'm probably understanding you wrong.

[blue_green_sparks]

@blue_green_sparks Could you please hold my hand and give me a 5 year old's explanation of how the above calculation was performed? My understanding is that you're saying $X would be your annual income from a portfolio if you had invested in 10y treasuries on each of the various dates, but the amount of income does not seem to correlate with 10y yields available on those dates. So I'm probably understanding you wrong.

Yes, I made a sheet that has rows showing dates and amounts of each of our bonds and CDs as they mature over the next 5 years. Then I use the projected rate data to see what annual income I would get from each new bond if I immediately turned that freed-up cash into 10-year treasuries. I just added up the projected earnings to see the annual paycheck amount I would be receiving that 5th year. I recalculate every few days to see how the trend is going. It also helps me decide if I should bother to sell a fixed instrument at a loss before maturity. It looked like we would get a better raise from interest about a month ago.

I'd like to maintain around $35K+inflation from fixed interest investments to cover the balance of our expenses after rental income and completely avoid selling stocks. $50K or more would be great.

[MrGreen]

Well this is awkward. The stock market rally today in the wake of Powell's comments puts the Dow in a new technical bull market.

[EscapeVelocity2020]

Seemed a little premature given that PCE data is released tomorrow.  Of course, this market is willing to rally sharply on any shred of good news.  I think there is a lot of professional money in puts and shorts, what with the Fed still tightening, QT’ing, and inflation not coming to heel…. But what do I know, I’m just along for the ride!

[dividendman]

Well this is awkward. The stock market rally today in the wake of Powell's comments puts the Dow in a new technical bull market.

I guess the top is in?

[ChpBstrd]

Well this is awkward. The stock market rally today in the wake of Powell's comments puts the Dow in a new technical bull market.

Yea, Powell pretty much tipped us off that December will be a 0.5% hike. The futures and stock markets took this as a sign the February and March hikes will be 0.25% each, and the terminal rate will be 5%.

I do not know why the market should consider a slowing pace of rate hikes to equate to a lower peak rate. If a recession is coming at date X to stop the rate hikes, then yes, the smaller each rate hike the lower the terminal rate. But if a recession is imminent, shouldn't we be getting out of stocks, rather than piling in on the hopes that the peak rate is 5.00% rather than 5.25%? The optimism and rationalization are breathtaking, so it feels very much like we're in the denial phase.

Powell also talked a lot about "transitory" features of the current economy, such as a still-low labor participation rate, COVID-related supply chain bottlenecks, and the housing bubble. He is still an inflation dove at heart, and seems to believe that inflation can be brought back to 2% without necessarily causing a recession, because inflation is due to a series of one-off factors. He repeated that we have an "n of one" when it comes to post-pandemic inflation control after massive stimulus, suggesting that he's looking harder at narratives and events than economic models. We actually have an "n of several" if you think in terms of models based on historical data instead of incidentals.

Powell's attitude seems to ignore the money supply issue. GDP and monetary velocity were released today. GDP grew at a 2.9% annualized rate, but look what is happening to the velocity of money:


As the money supply contracted over the past several months due to QT, the velocity of money has increased because a smaller number of dollars must change hands more quickly to perform a growing amount of transactions. We're only down to the M1 and M2 levels seen 10-12 months ago, and yet prices are 7.78% higher than a year ago and GDP is up. I.e. M1 and M2 would have to grow that much just to maintain the same velocity and not go into disinflation. Instead we're reducing money supply. The monthly inflation numbers have been falling since soon after QT went into effect, which is why I suspect QT is more powerful than the FOMC thinks it is.
M1 and M2 have moved in lockstep lately, as QT comes out of both.


Meanwhile, the National Financial Conditions Index suggests banks and bond investors are loosening the purse strings and making it easier for companies to borrow. This metric usually touches or exceeds zero right before a recession, but it can also turn on a dime. This metric suggests recession might not be imminent and lenders are becoming more certain about their policy predictions.


The latest ADP jobs report was essentially flat, even as the number of jobs openings continued to fall. As Powell pointed out, there are still considerably more job openings than unemployed people, but the slack is starting to reel out.



To summarize all this: GDP, monetary velocity, jobs, and the NFCI all suggest the economy has not yet begun to significantly weaken, despite all the rate hikes and QT of the past few months.

A recession that saves us from inflation might not come in the next 6-12 months, so all this hope about a 5% peak Federal Funds Rate might be as premature as all the earlier hope-induced rallies of 2022. However, QT is reducing money supply fast enough that it will eventually constrain banks' ability to lend (because they bought so many treasuries rather than lending out depositors' money) and that'll lead to falling demand and job losses. We just don't know how soon. Maybe it makes sense to be less assured than the markets that rate hikes at a 0.5% or 0.25% pace won't add up to 6-7% by the end of next summer, if the economy continues its burn-up. We also can't be so sure commodities won't rally again, leading inflation right back up.

Basically, you have to thread a few needles at the same time for a 0.25% lower rate hike in December to translate to a 0.25% lower peak FFR. I remain skeptical and neutrally positioned. We'll have either a recession fire-sale on stocks OR very high bond yields to feast on in 12 months, or maybe both.

[dividendman]

Basically, you have to thread a few needles at the same time for a 0.25% lower rate hike in December to translate to a 0.25% lower peak FFR. I remain skeptical and neutrally positioned. We'll have either a recession fire-sale on stocks OR very high bond yields to feast on in 12 months, or maybe both.

So are you giving a very low probability to a "soft landing"? i.e. Rates get up to 5% (but not higher), GDP growth comes in low, but not recessionary, and supply chain bottlenecks ease, employment bottlenecks ease, giving us a multi-year economic boom?

What's the probability that Powell's origin hypothesis of "transitory" inflation is correct but it's just transitory for 6-8 quarters instead of a couple of quarters?

edited to add: is there a possibility of a sector based recession, say in housing, that doesn't tank everything else?

[MrGreen]

@ChpBstrd I love all the data you guys throw out in this thread. It makes a lot of sense but I do think there is a little "this has never happened before" factor (meaning a pandemic whipsaw of supply and demand, supply chain issues, government stimulus, global connectedness, etc.) that puts an asterisk on what's happening right now. Powell seems to be making the right moves for now. He's saying there's still a ways to go, which covers the "inflation is tougher to tame" scenario and if we do start to see inflation truly easing they can just stop hiking rates. It's truly fascinating to see all this play out.

[Viking Thor]

Well this is awkward. The stock market rally today in the wake of Powell's comments puts the Dow in a new technical bull market.

SP 500 still down roughly 15% YTD and total stock market more than that.

Dow in my opinion is a silly \ meaningless metric that exists only for the media to reference when it gives a surprise sounding result that's good for headlines.

Its 30 stocks weighted by stock price rather company value and is therefore not a good indicator of the stock market. (Eg McDonald's is weighted more than Microsoft, even though Microsoft is a much more valuable company)

You probably know this already, but just just pointing out because this is all over headlines today, and I always think it's misleading when the press touts it in these situations to essentially create a false narrative.

[MrGreen]

@Viking Thor I know the Dow is exclusively large cap. The S&P needs to rise 10% more to be in a technical bull market. Though I still find it a bit shocking given all the talk of an impending recession. Of course now people are starting to question how soon this recession might come, given the Q3 GDP data and other metrics coming in. Strange but interesting times for sure.

[Viking Thor]

Yes it's definitely strange times now, hard to say what's coming in the short term.

The current YTD  stock slide while not enormous is still significant considering ~8% inflation this year, so a real return of around 20% down.

Nowhere near historic big declines but still substantial. Company profits have also been healthy, so some amount of decline\ mild recession is built into stock prices.

Of course a bigger decline than anticipated \ priced in would bring stocks down further.

[EscapeVelocity2020]

@ChpBstrd I'm not so sure why it's hard for the Fed to understand, but you put a huge QE package (capital T's outlay) out there and the billionaires that do things like buy a worth a whole lot less Twitter for a loan on their equity, which increases the velocity of money...  The US is in for a long and hard bout of above 2% inflation...

I'm not an economist, but I'm like please don't follow up Mr. Nobel Prize by showering even more money on a saturated economy...

[MrGreen]

@Viking Thor One might also point to previously high P/E ratios and make an argument that some of the market drop was needed even without the prospect of a recession.

Today's PCE data came in pretty much as expected. Overall dropped to 6% annual. Core PCE dropped to 5%.

[ChpBstrd]

So are you giving a very low probability to a "soft landing"? i.e. Rates get up to 5% (but not higher), GDP growth comes in low, but not recessionary, and supply chain bottlenecks ease, employment bottlenecks ease, giving us a multi-year economic boom?

By December, we will have raised rates 4.25%. There have been 5 instances of rate hikes of at least 4.25% since 1954:

2004-2006: +~4.25% result: recession in 2008
1980-1981: +~10% result: recession in 1981
1977-1980: +~13% result: recession in 1980
1972-1974: +~9.5% result: recession in 1974
1967-1969: +~6% result: recession in 1970

There have also been four recessions that followed rate hiking campaigns smaller than 4.25%, such as 1957-58 (+2.65%), 1960-61 (+3.37%), 1990 (3.25%), 2001 (2%), and 2020 (2.25%).

Cases where a series of rate hikes did not lead to recession are limited to the 3.75% hikes between 1961 and 1966, and the 3% hikes between 1993 and 1995. That's it.

So there's a 100% historical precedent where rate hikes of at least 4.25% lead to a recession. We'd be in that category even if December was the last rate hike. Looking at it another way, anytime we know we are in a rate hiking campaign of at least 2%, as we know now, the odds of escaping without a recession are 2/10. Those two escapes occurred after rate hiking campaigns below +4% and during times of more reasonable asset valuations.

So yes, I think a recession is very likely in 2023 or 2024.

@ChpBstrd I love all the data you guys throw out in this thread. It makes a lot of sense but I do think there is a little "this has never happened before" factor (meaning a pandemic whipsaw of supply and demand, supply chain issues, government stimulus, global connectedness, etc.) that puts an asterisk on what's happening right now. Powell seems to be making the right moves for now. He's saying there's still a ways to go, which covers the "inflation is tougher to tame" scenario and if we do start to see inflation truly easing they can just stop hiking rates. It's truly fascinating to see all this play out.

Yes, every moment in economic history is unique in an infinite number of ways. I see econ as one of the behavioral sciences, with outcomes not necessarily predictable from the physics-style equations crafted by econ professors. Also, sometimes thinking based on historical precedent leads to surprises, such as the failure of classical economics during the Great Depression, failure of the Phillips Curve in the 1970s, or the failure of inflationary assumptions in the 20-teens. There is a limited amount we can know about the future in econ, because there are so many variables, and some of them are non-rational.

For these reasons, I'm shying away from academic theories aside from the simple Taylor Rule, and sticking with what patterns and incentives we can recognize.

• Do 4%+ rate hikes cause recessions? Yes.
• Has CPI over 7% ever fallen and stayed down while the FFR<Core CPI? No.
• Do consumers pull ahead purchases when they expect high inflation in the future, or when they can borrow at less than the rate of inflation? Yes.

The pitfall of "this time is different-ism" is that we claim agnosticism about truths we should know with high certainty, based on decades of experience. I think I'm cutting a fair compromise between the risk of type-1 versus type-2 error.

FWIW, I see most of the "different" things this time as inflationary. A low labor participation rate is creating imbalances between supply and demand. Supply chain issues are raising prices. Government stimulus has increased the money supply. De-globalization is raising prices. QT is the only disinflationary new factor, which is why I focus on it a lot to see if it can bail out the other issues.

Yes it's definitely strange times now, hard to say what's coming in the short term.

I'm not so sure it is hard to say whether a recession is coming or not, except if we're talking about how we don't want it to be the truth.

A recession is simply a period of negative economic growth, which is not hard to imagine considering that our comparison years of 2020-2022 were a boom time for consumption, fueled by the direct stimulus payments of 2020-2021, with unemployment falling as far as it's ever fallen. Anything less than that level of economic frenzy will be a recession, even if we only return to more typical conditions such as 4-6% unemployment.

[dividendman]

Has CPI over 7% ever fallen and stayed down while the FFR<Core CPI? No.

Even if this holds, we'll have a FFR of 4.25% shortly, today's core CPI numbers are up 5% YoY and 0.2% in October (which extrapolates to 2.4%/y if that holds), this is in the face of robust consumer spending. Maybe by February the core CPI will be 4.75% and the FFR will be 5%? Is that all it takes it beat inflation?

Also, with the market down 15% YTD isn't there a good argument that any very mild recession has already been priced-in? Note we did have two quarters of negative GDP growth this year.

I'm really close to saying "f it" and just put some of my bond allocation into LTT or a lifetime annuity. I do have a significant portion of my bond allocation in 6-month T-Bills which all mature by May, let's see if the timing is good :)

[ChpBstrd]

Has CPI over 7% ever fallen and stayed down while the FFR<Core CPI? No.

Even if this holds, we'll have a FFR of 4.25% shortly, today's core CPI is numbers are up 5% YoY and 0.2% in October (which extrapolates to 2.4%/y if that holds), this is in the face of robust consumer spending. Maybe by February the core CPI will be 4.75% and the FFR will be 5%? Is that all it takes it beat inflation?

Markets seem to think so, but I am skeptical. When I look at a graph of CPI, Core CPI, and the FFR, (see below) what I see is:

• The only other times CPI or Core CPi is > the FFR is a few months in 1971, right after the 1974 recession, for a brief time in the early 1990s after the 1991 recession, after the 2001 recession, and after the GFC. All these historical episodes occurred after recessions, whereas today the FFR/inflation inversion is occurring before a recession.
• Of these stimulative episodes, the only time when CPI got as high as it got this year was the 1974 episode. The 1970 episode came close at 6.6% Core CPI, which matches September 2022. In both of those cases, the Arthur Burns Fed was criticized for being too dovish and making too many "transitory" excuses for inflation, like the Yom Kippur war, drought, or oil prices. Sound familiar? I feel like I saw a speech just yesterday making similar points about the pandemic.
• The possible result of leaving the FFR below CPI/Core CPI for a matter of months, post-recession, in 1970 and 1975 was the rebounds of inflation that started about 2 years later in each case.
• Paul Volker finally killed inflation in the early 1980s by maintaining a consistent, positive spread between the FFR and CPI. Sometimes this spread was 8% wide.

https://fred.stlouisfed.org/graph/?g=X2TS

Also, with the market down 15% YTD isn't there a good argument that any very mild recession has already been priced-in? Note we did have two quarters of negative GDP growth this year.

I'm really close to saying "f it" and just put some of my bond allocation into LTT or a lifetime annuity. I do have a significant portion of my bond allocation in 6-month T-Bills which all mature by May, let's see if the timing is good :)

On January 1, 2022, the S&P500 PE ratio was 23.11. That's an earnings yield of (1/23.11=) 4.33%. Today, the S&P500 PE is 21.17, an earnings yield of 4.72%. I don't see this shift as pre-recession positioning. If anything, it's only an admission that long-term growth will be slightly slower at today's interest rates. The average drop in S&P500 earnings during recessions has been 26% since 1990. I don't think people buying a 4.72% earnings yield are accounting for an average recession, because that 4.72% earnings yield would be expected to become 3.5% if the average outcome happened, and maybe not recover for a couple of years. That's less than 10 year treasuries are yielding.

Of course, PE ratios typically go through the roof during recessions because investors are always forward looking and they don't mark down their stocks proportionally to the previous 12 months' earnings. Yet from our current pre-recession vantage point, I don't see any adjustment being made for earnings to fall. I don't even see an adequate amount of adjustment being made for higher interest rates. A lot of companies will have to de-leverage over the next few years to optimize their capital structure for higher rates or just pay more in interest, and either way that can only come out of cash flows to equity.

The gap between treasury yields and the stock market's earnings yield is narrowing back to where it was in the 1980s and 1990s, after 2 decades of sharp divergence. If you think we have a recession ahead that will be accompanied by rate cuts and even deeper yield curve inversions, then it might be a good time to load up on long-duration bonds. Perhaps that is why yields have fallen this month, as more and more recession warnings go off, like manufacturing and sentiment reports.

I too picked up a bunch of 6-month T-Bills maturing in 2023. I think by mid-late 2023 we'll either have higher rates on long-duration bonds OR lower valuations on stocks OR both. To buy that dip, I'll need to not ride the dip down!

I think that besides the bear rallies, it's unlikely we'll be coasting toward what one former Fed governor recently dubbed an Immaculate Disinflation. However we should be thinking on a 1-2 year time frame, not 1-2 quarters. I see most people thinking only 1-2 quarters ahead.

[MustacheAndaHalf]

I think that besides the bear rallies, it's unlikely we'll be coasting toward what one former Fed governor recently dubbed an Immaculate Disinflation. However we should be thinking on a 1-2 year time frame, not 1-2 quarters. I see most people thinking only 1-2 quarters ahead.

The term "immaculate disinflation" was coined over 8 months ago.  I believe at the time the Fed believed inflation could be brought under control without unemployment going up at all.  Others said the Fed was in "la la land".

Really hoping that "immaculate disinflation" (coined by Mike Feroli, quoted by me in this story) catches on as a Fed Phrase.

https://twitter.com/jeannasmialek/status/1504426576070463489?lang=en

[ChpBstrd]

One of these things is not like the others. See if you can spot it!

• GDP growth was 2.9%. https://www.newsweek.com/us-gdp-bump-confounds-expectations-despite-recession-fears-1763394
• Hourly wage growth is now back above 5%, breaking a four-month downward trend. https://fred.stlouisfed.org/graph/?g=XdNf
• The NFCI has been falling since early October, suggesting normalization of lending markets and movement away from recessionary conditions.https://fred.stlouisfed.org/series/NFCI
• The economy produced 263k jobs in November, overshooting expectations by 31%. https://www.msn.com/en-us/money/markets/november-jobs-report-payrolls-rise-by-263-000-unemployment-rate-holds-at-3-7/ar-AA14NBic
• The ISM's service-sector index released on 12/5 rose to 56.5% in October. https://www.marketwatch.com/story/the-u-s-economy-is-still-growing-ism-finds-even-as-warning-signs-mount-11670253012?mod=home-page
• The Manufacturing, Shipments, and Inventory (M3) survey released on 12/5 showed orders for durable goods, machinery, and other things grew quickly in October, suggesting people and businesses are still pulling ahead purchases and planned capital expenses. https://fred.stlouisfed.org/release?rid=95
• Jerome Powell gave a presentation on 11/29 outlining the case for why the inflation of 2021-2022 was due to one-off non-monetary factors that would resolve on their own, and suggested a tapering of Fed rate hikes to 0.5%.

The economy is still growing after nine months of the aggressive rate hikes investors have been anguishing over. Yet, Powell sees the July-October disinflation trend (which seems to have been driven by a commodities correction) as a sign that transitory factors are lifting. James Bullard has meanwhile been talking to anyone who will listen about the Taylor Rule, and how it says rates should be between 5% and 7% right now, depending on which assumptions we use, not 4%. https://www.stlouisfed.org/-/media/project/frbstl/stlouisfed/files/pdfs/bullard/remarks/2022/nov/bullard-louisville-17-nov-2022.pdf?sc_lang=en&hash=4725A924300B1A6777E788822AF33277

I've asked this before: Is policy still stimulative? The economic data mentioned above say yes.

Bullard certainly thinks so, and he has what I consider to be a persuasive model to show it.

Powell and the other inflation-doves seem to have a series of incidental excuses by comparison - the pandemic, the Ukraine war, supply chains, long COVID, people just don't want to work, yada yada.

The dovish argument sounds a lot like what I've read about 1970's Fed Chair Arthur Burns and his excuses like the Yom Kippur war, OPEC, drought, shortages, core inflation, etc. It's all true, but it doesn't matter that it's all true, or what the sources of the inflation were. We still have an inflation problem, and still have to enact a monetary solution rather than wishfully hoping the issues resolve inflation by resolving themselves.

I don't expect next Tuesday's CPI report to blow anyone's mind. 7.5% CPI growth and 6.1% Core CPI growth sound about right to me.

Yet I wonder how long speculators can stay out of commodities when by all indications the economy is growing fast, with the FFR 3% lower than CPI inflation and almost 4% lower than PCE inflation. It's a game of chicken with the coming recession, but if demand is still accelerating and Powell is all but unfurling the "Mission Accomplished" banner on inflation, then it might make sense for commodities users to lock in today's prices. The more evidence piles up that the economy is accelerating, the more speculators will get off the sidelines and back into one of the key drivers of inflation. <--- That's a recipe for a commodities comeback in Q1 or Q2 that could give us a 2nd peak on the headline inflation numbers.

Commodities users and speculators are reluctant to lock in future supply because a recession seems so likely in the future. Users would be left with too much supply and not enough capital. Speculators would be left with massive price losses. Yet, their position is at odds with the actual performance of the economy in this pre-recession period. That tension is going to whipsaw markets and inflation until the recession is here. We're seeing firsthand why bear market rallies occur, why economies can overheat through a year or two of Fed rate hiking campaigns, and how inflation sets up incentives to perpetuate itself.

[ChpBstrd]

I grabbed the following screenshot from
https://www.youtube.com/watch?v=ZGRedyWAp34

This video is John Taylor, author of the Taylor Rule, in February 2022 showing how:
1) The Taylor Rule showed the FOMC was behind the curve long before most people became aware inflation was a problem.
2) How the Taylor Rule was prescribing a 5-7% FFR way back then when people were speculating about 3.5% as a likely terminal rate.
3) How each of the inflation episodes of the 1970's were associated with the FFR being far below what the then-nonexistent Taylor Rule would have prescribed, and the episode in the early 1980s when fast disinflation coincided with the FFR being far higher than the Taylor Rule would have prescribed.

Of course, there is something to criticize here. The Taylor Rule, as well as most theories of inflation, failed to predict inflation would stay low in the post-2009 era. Perhaps the FOMC looked at the 2010-2020 FFR - Taylor FFR gap and predicted 2020-2022 would look similar? Or perhaps the Taylor Rule doesn't predict when inflation will break out, but only prescribes how to extinguish it if it does get out of hand? I.e. regardless of the causes of inflation, the Taylor Rule tells what we need to do to crush it.

As long ago as February 2022, the math said it would take a FFR in excess of about 7%.

[MustacheAndaHalf]

The stimulus used in the global financial crisis went to large banks, which normally means that money enters the economy.  But it didn't - the banks kept the money for themselves, placing more value on having additional capital rather than more investments.  Since the money never left the banks, I think that money could have created some erroneous signals - perhaps for the Taylor rule.

John Taylor himself said this on Nov 11 2022:

The Federal Reserve needs to raise interest rates significantly higher, to perhaps 6%, to reduce inflation, influential monetary economist John Taylor said on Friday.

https://www.bloomberg.com/news/articles/2022-11-11/fed-may-need-to-raise-rates-to-6-monetary-expert-taylor-says

I suppose the key thing here is that economist John Taylor has been more accurate than the Fed, so I might rank his opinion higher than Fed Chair Powell for now.  One of the slides in that talk claims the Wall Street Journal was early to raising concerns about inflation, so it might also be helpful to follow WSJ articles on inflation.

There are two beliefs the market currently holds which I find very unlikely: (1) they can predict inflation - it will fall rapidly in 2023, and (2) a soft landing will result.  Historically nobody can predict inflation accurately - not even the Fed, which can influence it.  So beliefs about where inflation will be are suspect.  With a soft landing, in similar conditions of Fed tightening (QT, open market operations, ...) the result has always been a recession.  A soft landing may be possible, but history shows it to be very unlikely.

Which leads me to a simple conclusion: invest against the market.  When investors/the Fed stop believing they can predict inflation, and that an improbable event is the base case, then I might rejoin the market.  My active investing currently consists of roughly 1/3rd put options and 2/3rds cash.  Markets are volatilie enough that I worry 3x ETFs will suffer too much volatility drag, which is why I favored put options (and their very cheap time value cost, as of Dec 2)

[ChpBstrd]

The stimulus used in the global financial crisis went to large banks, which normally means that money enters the economy.  But it didn't - the banks kept the money for themselves, placing more value on having additional capital rather than more investments.  Since the money never left the banks, I think that money could have created some erroneous signals - perhaps for the Taylor rule.

There's probably something to that explanation. As I recall, financial institutions spent several years after the GFC evicting people and liquidating a backlog of underwater houses, some with squatters and damages. That hangover probably reduced their ability to lend, but also as I recall, loans were readily available. The NFCI stayed in heatlhy condition the whole time except for a brief period in 2011. It's just that consumers and businesses were a bit traumatized, under-capitalized, and saddled with damaged credit after the GFC.

It may seem odd to some, but this is why I see trends in the Personal Savings Rate (PSR) as a primary clue about where inflation is heading. A low or falling savings rate implies a high or rising velocity of money. The fewer dollars being saved by consumers, the more quickly dollars are being redeployed in the marketplace to become somebody else's earnings, and vice versa.
https://fred.stlouisfed.org/series/PSAVERT

The 2004-2007 housing bubble / inflation increase was associated with the PSR falling from around 5% to a low of 2.8% in November 2007.
The 2009-2019 period of low inflation was associated with a rising trend in the PSR, from 4.5% in August 2009 to 9.1% in January 2020.
The 2021-2022 period of high inflation was associated with a sharply falling PSR, which went from >9% in mid-2021 to a mere 2.3% in October as consumers pulled ahead their future purchases, partially with stimulus money.

The economic and inflation/disinflation cycle to some extent can be summarized as customers spending an increasing percentage of their earnings during the growth and inflation phase, and then hitting the brakes and trying to increase solvency during the recession and disinflation phase.

The Taylor Rule does not account for fluctuations in the PSR, except to the extent it affects the output gap, and it certainly does not account for QE/QT or helicopter money or barely-solvent banks. This may be why it failed as a predictive tool in the 20-teens. I'm increasingly thinking we're misusing the Taylor Rule if we expect it to predict inflation from a wide number of causes that are not inputs. It's the Taylor Rule and not the Taylor Theory because John Taylor's only intent was to establish a model which prescribes how the Fed should raise or lower inflation.

Maybe inflation or disinflation can come from a wide number of causes, but regardless must be dealt with using the medicine of interest rates as prescribed by Taylor's Model. It's like how cancer can occur due to a wide range of causes, but the necessary dosage of a cancer drug is based on a handful of variables unrelated to the causes. We cannot expect the dosing formula to predict cancer, but we can use it to administer enough of a dose to have the desired effect once there is cancer.

Thus we can say:
"According to the Taylor Rule, the Fed is insufficiently constricting the economy to get inflation under control"

...but we cannot say:
"According to the Taylor Rule, inflation will keep rising."

It's a subtle difference. I've been guilty in this thread, but I'll try to stop using the Taylor Rule as a theory, despite the juicy parallels with the 1970s when insufficient doses of rate hikes were followed by inflation resurgences.

I agree Taylor is more useful as an info source than Powell. Powell is politically constrained from telling us what he really thinks, even if it is that the FFR is heading to 7% and a severe recession with no help from the Fed is unavoidable. He'll act as surprised as the rest of us regardless of what happens because he needs to deflate the economy, not pop it. However Powell's "higher for longer" talk should get our attention. Rate cuts might be minimal or off the table during the next recession, based on the 1970s experience. That will be the difference between a mild recession and a severe one. Every recession of our lifetimes was turned around after rate cuts, but how bad does a recession get without them? Unemployment exceeded 6% in the 1971 recession, exceeded 8% in 1975, and hit 10% in 1982, and those were each followed by rate cuts!
https://fred.stlouisfed.org/series/UNRATE

[EscapeVelocity2020]

Now that we are out of the latest political cycle, I wonder if the Fed's messaging will become more pointed?  It does no one no good to lily-foot around our economic situation throughout 2023 if inflation remains stubbornly high.  For example, personally, my wages are going up but my groceries are also costing me more, so I'm pretty grumpy, yet I'm one of the lucky ones with a job I enjoy and a paid off mortgage...  I could do this for a few more years without really complaining. 

Can't imagine how much longer this is tenable for folks coming up short just trying to live their same not so satisfying life...

[thorto0803]

CPI 0.1% Core 0.2% (2.5% annual rate). What does this mean for the Taylor rule? Is this the additional effect of QT on top of rate hikes?

[wageslave23]

CPI 0.1% Core 0.2% (2.5% annual rate). What does this mean for the Taylor rule? Is this the additional effect of QT on top of rate hikes?

First rule of this thread - Never question the Taylor Rule ;)

[ChpBstrd]

CPI 0.1% Core 0.2% (2.5% annual rate). What does this mean for the Taylor rule? Is this the additional effect of QT on top of rate hikes?

I've been thinking about exactly that. What if QE/QT are having more powerful effects than anyone gives credit for? The problem is this: How can QE explain both the high inflation of 2021-22 AND the low inflation of 2009-2019?

Suppose we said, for example, that the Fed's current levels of QT are like a 2% rate hike, and by that measure current policy is equivalent to a 6% interest rate in the absence of QT. This puts us within the range of possibly-restrictive outcomes as calculated by the Taylor Rule, and that would explain why inflation has been falling since June.

However, what do we say about QE? Many billions of dollars were created due to QE in the 20-teens while interest rates were also near the zero boundary. Does that mean policy was equivalent to negative interest rates - maybe -2% - and if so why didn't that cause higher inflation?

The best explanation I've heard is that the 20-teens QE never really left the banking sector. The Fed purchased financial assets from banks, which merely caused them to buy more financial assets from the government to replace the assets they sold to the government. Thus the money created by 20-teens QE never entered the Main Street economy of transactions for goods and services. It was merely the government printing money to fund itself which does not directly affect the demand for or price of any particular thing, especially amid voracious foreign demand for US treasuries.

The 2020-2021 period, however, included direct payments to consumers, which resulted in immediate increases in aggregate demand. Thus, maybe it wasn't the QE of the period that made the inflation, as much as it was the stimulus payments. The rate at which these stimulus funds disappeared from the Main Street economy and ended up in tax coffers, foreign reserve accounts, and treasuries hit an inflection point this summer, and now most of the stimulus money is gone to sit stagnant in those accounts rather than being spent.

One could come up with a theory in which QT in addition to the eventual flow of stimulus money out of the Main Street economy have created conditions similar to 6% or higher interest rates. By that logic, QE, QT, and stimulus are insulating us from the much larger swings in interest rates and economic conditions that would be necessary if interest rates were the Fed's only tool. I.e. rates may only rise to 5% instead of 7%, in apparent violation of the Taylor Rule, but inflation may fall anyway due to a plummeting money supply thanks to QT and the run-off of stimulus spending.
https://fred.stlouisfed.org/series/M2SL

[index]

CPI 0.1% Core 0.2% (2.5% annual rate). What does this mean for the Taylor rule? Is this the additional effect of QT on top of rate hikes?

I've been thinking about exactly that. What if QE/QT are having more powerful effects than anyone gives credit for? The problem is this: How can QE explain both the high inflation of 2021-22 AND the low inflation of 2009-2019?

Suppose we said, for example, that the Fed's current levels of QT are like a 2% rate hike, and by that measure current policy is equivalent to a 6% interest rate in the absence of QT. This puts us within the range of possibly-restrictive outcomes as calculated by the Taylor Rule, and that would explain why inflation has been falling since June.

However, what do we say about QE? Many billions of dollars were created due to QE in the 20-teens while interest rates were also near the zero boundary. Does that mean policy was equivalent to negative interest rates - maybe -2% - and if so why didn't that cause higher inflation?

The best explanation I've heard is that the 20-teens QE never really left the banking sector. The Fed purchased financial assets from banks, which merely caused them to buy more financial assets from the government to replace the assets they sold to the government. Thus the money created by 20-teens QE never entered the Main Street economy of transactions for goods and services. It was merely the government printing money to fund itself which does not directly affect the demand for or price of any particular thing, especially amid voracious foreign demand for US treasuries.

The 2020-2021 period, however, included direct payments to consumers, which resulted in immediate increases in aggregate demand. Thus, maybe it wasn't the QE of the period that made the inflation, as much as it was the stimulus payments. The rate at which these stimulus funds disappeared from the Main Street economy and ended up in tax coffers, foreign reserve accounts, and treasuries hit an inflection point this summer, and now most of the stimulus money is gone to sit stagnant in those accounts rather than being spent.

One could come up with a theory in which QT in addition to the eventual flow of stimulus money out of the Main Street economy have created conditions similar to 6% or higher interest rates. By that logic, QE, QT, and stimulus are insulating us from the much larger swings in interest rates and economic conditions that would be necessary if interest rates were the Fed's only tool. I.e. rates may only rise to 5% instead of 7%, in apparent violation of the Taylor Rule, but inflation may fall anyway due to a plummeting money supply thanks to QT and the run-off of stimulus spending.
https://fred.stlouisfed.org/series/M2SL

I would say some of the inflation experienced is supply chain related and transitory. Used car prices exploded because new cars were not available and rental agencies and corporate fleets became consumers of gently used cars rather than suppliers. There are numerous examples of the same phenomenon.

A certain amount of QE is necessary to prevent domestic deflation because of foreign demand for USD and USD denominated debt. QT sucks liquidity out of the system, but USDs are being exported overseas at the same time. In addition, "some" of the QE seen during the pandemic offset real losses by businesses and individuals so it is not completely inflationary.

I agree that a lot of the QE in the teens stayed on bank balance sheets, but there was also a huge destruction of USDs with the collapse of the housing market. Much of the new USDs when into re-inflating the housing market.

If 1-2% of inflation is supply chain related and QT has a 1-2% impact then the Taylor rule can be achieved with a headline FFR 2-4% under headline inflation. Keep in mind the increase in the FFR torpedoed the velocity of the housing due to affordability issues which is a huge component of the inflation formula and is still shaking itself out.       

[wageslave23]

CPI 0.1% Core 0.2% (2.5% annual rate). What does this mean for the Taylor rule? Is this the additional effect of QT on top of rate hikes?

I've been thinking about exactly that. What if QE/QT are having more powerful effects than anyone gives credit for? The problem is this: How can QE explain both the high inflation of 2021-22 AND the low inflation of 2009-2019?

Suppose we said, for example, that the Fed's current levels of QT are like a 2% rate hike, and by that measure current policy is equivalent to a 6% interest rate in the absence of QT. This puts us within the range of possibly-restrictive outcomes as calculated by the Taylor Rule, and that would explain why inflation has been falling since June.

However, what do we say about QE? Many billions of dollars were created due to QE in the 20-teens while interest rates were also near the zero boundary. Does that mean policy was equivalent to negative interest rates - maybe -2% - and if so why didn't that cause higher inflation?

The best explanation I've heard is that the 20-teens QE never really left the banking sector. The Fed purchased financial assets from banks, which merely caused them to buy more financial assets from the government to replace the assets they sold to the government. Thus the money created by 20-teens QE never entered the Main Street economy of transactions for goods and services. It was merely the government printing money to fund itself which does not directly affect the demand for or price of any particular thing, especially amid voracious foreign demand for US treasuries.

The 2020-2021 period, however, included direct payments to consumers, which resulted in immediate increases in aggregate demand. Thus, maybe it wasn't the QE of the period that made the inflation, as much as it was the stimulus payments. The rate at which these stimulus funds disappeared from the Main Street economy and ended up in tax coffers, foreign reserve accounts, and treasuries hit an inflection point this summer, and now most of the stimulus money is gone to sit stagnant in those accounts rather than being spent.

One could come up with a theory in which QT in addition to the eventual flow of stimulus money out of the Main Street economy have created conditions similar to 6% or higher interest rates. By that logic, QE, QT, and stimulus are insulating us from the much larger swings in interest rates and economic conditions that would be necessary if interest rates were the Fed's only tool. I.e. rates may only rise to 5% instead of 7%, in apparent violation of the Taylor Rule, but inflation may fall anyway due to a plummeting money supply thanks to QT and the run-off of stimulus spending.
https://fred.stlouisfed.org/series/M2SL

I would say some of the inflation experienced is supply chain related and transitory. Used car prices exploded because new cars were not available and rental agencies and corporate fleets became consumers of gently used cars rather than suppliers. There are numerous examples of the same phenomenon.

A certain amount of QE is necessary to prevent domestic deflation because of foreign demand for USD and USD denominated debt. QT sucks liquidity out of the system, but USDs are being exported overseas at the same time. In addition, "some" of the QE seen during the pandemic offset real losses by businesses and individuals so it is not completely inflationary.

I agree that a lot of the QE in the teens stayed on bank balance sheets, but there was also a huge destruction of USDs with the collapse of the housing market. Much of the new USDs when into re-inflating the housing market.

If 1-2% of inflation is supply chain related and QT has a 1-2% impact then the Taylor rule can be achieved with a headline FFR 2-4% under headline inflation. Keep in mind the increase in the FFR torpedoed the velocity of the housing due to affordability issues which is a huge component of the inflation formula and is still shaking itself out.       

I like this explanation.  Supply chain issues and the subsequent lack of supply coupled with the direct stimulus payments are really the only two things that have been different over the last few years compared to the previous 20+.  There may be other factors to explain inflation's recent behavior, but these have to be the two glaringly obvious variables.

[ChpBstrd]

CPI 0.1% Core 0.2% (2.5% annual rate). What does this mean for the Taylor rule? Is this the additional effect of QT on top of rate hikes?

I've been thinking about exactly that. What if QE/QT are having more powerful effects than anyone gives credit for? The problem is this: How can QE explain both the high inflation of 2021-22 AND the low inflation of 2009-2019?

Suppose we said, for example, that the Fed's current levels of QT are like a 2% rate hike, and by that measure current policy is equivalent to a 6% interest rate in the absence of QT. This puts us within the range of possibly-restrictive outcomes as calculated by the Taylor Rule, and that would explain why inflation has been falling since June.

However, what do we say about QE? Many billions of dollars were created due to QE in the 20-teens while interest rates were also near the zero boundary. Does that mean policy was equivalent to negative interest rates - maybe -2% - and if so why didn't that cause higher inflation?

The best explanation I've heard is that the 20-teens QE never really left the banking sector. The Fed purchased financial assets from banks, which merely caused them to buy more financial assets from the government to replace the assets they sold to the government. Thus the money created by 20-teens QE never entered the Main Street economy of transactions for goods and services. It was merely the government printing money to fund itself which does not directly affect the demand for or price of any particular thing, especially amid voracious foreign demand for US treasuries.

The 2020-2021 period, however, included direct payments to consumers, which resulted in immediate increases in aggregate demand. Thus, maybe it wasn't the QE of the period that made the inflation, as much as it was the stimulus payments. The rate at which these stimulus funds disappeared from the Main Street economy and ended up in tax coffers, foreign reserve accounts, and treasuries hit an inflection point this summer, and now most of the stimulus money is gone to sit stagnant in those accounts rather than being spent.

One could come up with a theory in which QT in addition to the eventual flow of stimulus money out of the Main Street economy have created conditions similar to 6% or higher interest rates. By that logic, QE, QT, and stimulus are insulating us from the much larger swings in interest rates and economic conditions that would be necessary if interest rates were the Fed's only tool. I.e. rates may only rise to 5% instead of 7%, in apparent violation of the Taylor Rule, but inflation may fall anyway due to a plummeting money supply thanks to QT and the run-off of stimulus spending.
https://fred.stlouisfed.org/series/M2SL

I would say some of the inflation experienced is supply chain related and transitory. Used car prices exploded because new cars were not available and rental agencies and corporate fleets became consumers of gently used cars rather than suppliers. There are numerous examples of the same phenomenon.

A certain amount of QE is necessary to prevent domestic deflation because of foreign demand for USD and USD denominated debt. QT sucks liquidity out of the system, but USDs are being exported overseas at the same time. In addition, "some" of the QE seen during the pandemic offset real losses by businesses and individuals so it is not completely inflationary.

I agree that a lot of the QE in the teens stayed on bank balance sheets, but there was also a huge destruction of USDs with the collapse of the housing market. Much of the new USDs when into re-inflating the housing market.

If 1-2% of inflation is supply chain related and QT has a 1-2% impact then the Taylor rule can be achieved with a headline FFR 2-4% under headline inflation. Keep in mind the increase in the FFR torpedoed the velocity of the housing due to affordability issues which is a huge component of the inflation formula and is still shaking itself out.       

I'm very reluctant to adjust the Taylor Rule due to transitory factors unrelated to rates, money supply, or velocity. The Taylor Rule was developed based on the 1970s experience when Fed chair Arthur Burns thought a series of transitory factors were responsible for inflation, such as oil supply chain interruptions, drought, strikes, and various one-off shortages. When each of these supposed causes resolved itself, there would appear new causes that seemed just as transitory. So the Taylor Rule sort of already factors in the assumption that inflationary influences will come and go. Hence my realization that the TR is ONLY a prescription for how much medicine the economy needs to take when various factors push inflation above the target. It has nothing to say about the causes of inflation, unless policy is kept below the prescription for a long time.

The introduction of QE, QT, and helicopter money has upended the simplicity of economic models from the era when interest rates were the Fed's only tool. These are systematic inflation influences, so I put them in a whole separate category than port congestion, semiconductor shortages, or oil prices.

[EscapeVelocity2020]

Can't find a link / reference to it, but NPR had an economist on that posited that the peak of inflation is relatively easy to fight, but as inflation gets down closer to the 2% target, it will become a much tougher battle for the Fed...  The prediction was for inflation to subside but remain elevated above 2% for several years. 

[index]

I'm very reluctant to adjust the Taylor Rule due to transitory factors unrelated to rates, money supply, or velocity. The Taylor Rule was developed based on the 1970s experience when Fed chair Arthur Burns thought a series of transitory factors were responsible for inflation, such as oil supply chain interruptions, drought, strikes, and various one-off shortages. When each of these supposed causes resolved itself, there would appear new causes that seemed just as transitory. So the Taylor Rule sort of already factors in the assumption that inflationary influences will come and go. Hence my realization that the TR is ONLY a prescription for how much medicine the economy needs to take when various factors push inflation above the target. It has nothing to say about the causes of inflation, unless policy is kept below the prescription for a long time.

The introduction of QE, QT, and helicopter money has upended the simplicity of economic models from the era when interest rates were the Fed's only tool. These are systematic inflation influences, so I put them in a whole separate category than port congestion, semiconductor shortages, or oil prices.

I think supply chain issues can be the the catalyst that leads to a wage spiral and stubborn inflation that is much more difficult to tamp down as observed in the 1970s. The Covid related supply chain issues were an order of magnitude worse than the oil shock in the 70s regarding the breadth of the "transitory inflation". The Fed needs to be careful and not overtighten which could lead to severe recession/deflation. This time 'could be' different. I imagine Powel and co will be watching wage increases through the new year and adjust their plan to prevent a put pressure on a wage spiral.

[BicycleB]

The Covid related supply chain issues were an order of magnitude worse than the oil shock in the 70s regarding the breadth of the "transitory inflation".

That sounds odd to me. I was only a kid then but afaik subsequent descriptions mostly supported my impression that the oil shock impact and resulting inflation were extremely broad.

I distinctly recall news reports at the time and magazine articles five to ten years later endlessly emphasizing that the impact of the oil shock was very broad - that oil affects everything because nearly all sectors of the economy use energy, that the inflation was widespread, etc. How could anything be an order of magnitude more than that?

[EscapeVelocity2020]

Unless the labor force actually begins to show signs of weakening in the reports, all this hand wringing about the Fed overdoing it seems a bit premature...  They are able to slow the rate of hikes which should provide more time between cause and effect, but right now, the labor force is heavily weighted toward wage growth (i.e. demand for labor far outstripping supply), despite all the scary headlines of layoffs and inevitable deep recessions.  Next reading on jobless claims is tomorrow.

[thorto0803]

Unless the labor force actually begins to show signs of weakening in the reports, all this hand wringing about the Fed overdoing it seems a bit premature...  They are able to slow the rate of hikes which should provide more time between cause and effect, but right now, the labor force is heavily weighted toward wage growth (i.e. demand for labor far outstripping supply), despite all the scary headlines of layoffs and inevitable deep recessions.  Next reading on jobless claims is tomorrow.

Agreed, initial unemployment claims have hardly budged, I think Powell is waiting until we see unemployment of at least 4.5% before he's going to start cutting. I could see the Fed doing another .5-.75 in increases (assuming CPI continues to be held in check) and then holding for a long time (2+ years). Even if a recession starts to hit hard, I foresee reluctance to cut rates in an effort to avoid a whiplash effect with inflation. I think the broad takeaway from the last 3 years is that direct payments to the middle/lower class have a very powerful stimulating effect on the economy. I wouldn't be surprised if this becomes a tool that congress uses (hopefully with a big more discretion on the timing and amounts) to combat recessions in the future.

[ChpBstrd]

Unless the labor force actually begins to show signs of weakening in the reports, all this hand wringing about the Fed overdoing it seems a bit premature...  They are able to slow the rate of hikes which should provide more time between cause and effect, but right now, the labor force is heavily weighted toward wage growth (i.e. demand for labor far outstripping supply), despite all the scary headlines of layoffs and inevitable deep recessions.  Next reading on jobless claims is tomorrow.

Agreed, initial unemployment claims have hardly budged, I think Powell is waiting until we see unemployment of at least 4.5% before he's going to start cutting. I could see the Fed doing another .5-.75 in increases (assuming CPI continues to be held in check) and then holding for a long time (2+ years). Even if a recession starts to hit hard, I foresee reluctance to cut rates in an effort to avoid a whiplash effect with inflation. I think the broad takeaway from the last 3 years is that direct payments to the middle/lower class have a very powerful stimulating effect on the economy. I wouldn't be surprised if this becomes a tool that congress uses (hopefully with a big more discretion on the timing and amounts) to combat recessions in the future.

Yea Powell seems particularly focused on the ~4+ million gap between available workers and available jobs, and the decline in the labor force participation rate. He mentioned this at Brookings and in today's press conference.
https://fred.stlouisfed.org/series/CIVPART

This abundance of jobs and lack of workers suggests strong upward wage pressures, which could lead to an inflationary spiral as workers demand more and more raises to keep up with a steadily rising average in their field. Powell's directly stated belief is that job losses can occur from this surplus of open jobs before anyone has to actually lose their job.

I also agree that Powell has told us for the umpteenth time that there will be no rate cuts in 2023. The FOMC's dot plot, however, shows an expectation for rate cuts in 2024 (perhaps after a recession becomes clear?) and an FFR down to 3% by 2025. This is why long-term treasuries have seen their yields fall.
https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20221214.pdf

Keeping rates around 4.75% or 5% for the next two years is probably the right thing to do to control inflation, but I'm increasingly seeing the logic behind expectating the FOMC will start cutting rates in 2024, a couple of quarters into the coming recession. That too would be consistent with Powell's measured statements in response to questions about when the FOMC will know they can lower rates again.

Regarding the use of direct stimulus to counteract recession: I think government stimulus money will soon come to be associated with inflation, rate hikes, and recession. As such, it will be a lot more difficult for political leaders to support in 2024 or 2025 than it was in 2020 and 2021. Meanwhile, the lesson learned from the Federal Reserve's QE of 2009-2018 was that while QE can help keep banks afloat, it does little for economic growth or inflation. If there's an argument about whether to do QE or to do tax refunds / stimmie checks, you can expect neither will be done.

In a perfect world, perhaps the stimulus of 2020-2021 would have been paired with tax hikes (reverse stimulus) in 2022-2023. That would have been perfect to prevent a depression in times of crisis AND reduce the inflation that would occur as a result of the stimulus. But of course that isn't politically possible.

[blue_green_sparks]

BlackRock's 2023 outlook summary:
https://www.blackrock.com/us/individual/insights/blackrock-investment-institute/outlook
Pricing the damage
Central banks are deliberately causing recession by overtightening policy to tame inflation, in our view. That makes recession foretold. What matters: our view on the pricing of economic damage and our assessment of market risk sentiment. Investment implication: We stay underweight DM equities but expect to turn more positive at some point in 2023.
Rethinking bonds
We see higher yields as a gift to investors long starved of income in bonds. And investors don’t have to go far up the fixed income risk spectrum to receive it. Investment implication: We like short-term government bonds, investment grade credit and agency mortgage-backed securities for income. We stay underweight long-term government bonds.
Living with inflation
Long-term trends of the new regime, such as aging workforces and geopolitical fragmentation, will keep inflation persistently above pre-pandemic levels, in our view. Investment implications: We stay overweight inflation-linked bonds on both tactical and strategic horizons. We are strategically overweight DM equities.

Northern Trust is expecting mid-single-digit equities returns in 2023.
https://www.northerntrust.com/united-states/insights-research/editorial-articles/economic-trends/global-economic-outlook-2023

Seems like higher yield fixed and even inflation linked bonds may truly be able to compete for returns against riskier equities in 2023.

[RWD]

BlackRock's 2023 outlook summary:
We stay underweight DM equities [...]
We are strategically overweight DM equities. [...]

?

[less4success]

They say they’re underweight in the short term and overweight in the long term. I assume this can be done using options.

[MustacheAndaHalf]

BlackRock's 2023 outlook summary:
We stay underweight DM equities [...]
We are strategically overweight DM equities. [...]

?

In the past, the Fed has lowered rates about 9 months after lowering them.  So if the Fed finishes in March 2023, they could start lowering rates by the end of 2023.  Even the most bearish strategist (Morgan Stanley's Mike Wilson) has this view: a crappy start to 2023, followed by a recovery later into the year.