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

[dangbe]

[...]

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The downturns in 1990 and 2000 both wouldn't have been preceded by a spike in this particular metric.  You bring up some good points though, and its good to have a wider view when attempting to predict whats going to happen.  All I really know right now is that uncertainty is high.

[Psychstache]

Thanks, FV! A fascinating read.

If behavioral economics was already being taught to undergrads I might have stayed in the major. The disconnect between the math we were being taught to predict the behavior of perfect utility maximizing agents and actual human decision making (i.e. "people and firms can be kinda stupid sometime") was too big for me to stay interested and engaged in class.

Right?  I was returning to school after escaping a religious cult (no bullshit).  I was struck by how much of the circular logic in a cult shows up in traditional economic models.  But what drives this?  "THE INVISIBLE HAND OF THE MARKET"  .... Your answer, and you swear it is 'academically robust', is literal fucking magic?!?  (And we swear this is a "hard science" while we are at it!)   I asked just enough hard questions to glean the 'correct answer for the test' and got on with my life. 

I have similar thoughts about the Academic Finance education I got with my later MBA and the handwavium behind Efficient Market Hypothesis. Ok, fine people are integrating all available information. But they are people, they are sort of insane, and very imperfect.  [You are telling me the same idiots who have collectively made the Kardashians and 8 dollar sickly sweet ice cold coffee "things" collectively get it right every single time with laser precision?!?  So said I - on the test.

I think there was a story in Liar's Poker about how Solomon Brothers got a bit of a cushion from the Black Monday crash of 1987 because one of their traders had just recently opened a huge short on the market because he was pissed his girlfriend broke up with him.

[Financial.Velociraptor]

Article on Yahoo! Finance germane to the discussion: https://finance.yahoo.com/news/a-strong-gdp-report-helps-biden-it-may-complicate-things-for-the-fed-165809376.html

TL;DR GDP growth exceeds expectations for Q4 and 2023 in whole; inflation's most recent reading at target.  March rate cut in jeopardy.

[ChpBstrd]

Article on Yahoo! Finance germane to the discussion: https://finance.yahoo.com/news/a-strong-gdp-report-helps-biden-it-may-complicate-things-for-the-fed-165809376.html

TL;DR GDP growth exceeds expectations for Q4 and 2023 in whole; inflation's most recent reading at target.  March rate cut in jeopardy.

I think it's reasonable to conclude the March rate cut is in jeopardy with GDP growth at an annualized 3.3% rate, but the market went the opposite way. Stocks rose, bond yields fell, and the Fedwatch tool actually INCREASED the odds of a March rate cut today.

So I'm trying to rationalize what seems on the surface to be illogical. Perhaps the market is looking at Q4 inflation numbers and thinking "If this is what inflation does amid 3.3% growth, then it is possible for the economy to grow quickly while inflation simultaneously falls to 2%." That is to say, the combination of GDP and CPI witnessed in recent months is a repudiation of the Phillips Curve. Maybe there is no tradeoff right now between inflation and unemployment.

This is also consistent with my belief that QT is having a much bigger effect on inflation than currently thought. In past inflation outbreaks, the FFR had to exceed the highest peak of inflation in order to send the trend in the opposite direction, and a recession always followed such an aggressive move. This time, the peak 5.5% upper bound FFR didn't even come close to matching peak 8.9% annual inflation, and yet a very strong inflation reversal occurred. This suggests the effect of $95B/mo QT is not 25bp of interest rates as JPow guesstimated - maybe more like 350-400bp! Recent experience also suggests, as I've noted before, that QT is a new inflation medicine that does not have nasty side effects on business conditions the way interest rates do. We could be looking at a new era when inflation control can be done without engineering recessions.

So there's a case to be made that the Fed should aggressively cut interest rates to keep real rates within the growth range, while letting QT do the work of crushing inflation for a few more months until we hit 2.5% or so. IF the Fed is thinking along these lines and IF they are alarmed by the prospect of undershooting inflation as it falls so quickly, then they should start cutting ASAP - which is March.

The main caveat here is the word "should" which is a great way to think if one wants to be wrong about what the Fed will eventually do and when they will do it. FOMC members are thinking at a more theoretical level, and trust their data less than most people do.

The second caveat is whether the Fed is willing to undershoot inflation for a while. A few years ago they said they'd let inflation overshoot. If the Fed is only trying to manage the long-run range of inflation, is willing to tolerate extended variances from policy goals, and is happy to act maybe 6-18 months behind the trend, then the pace of rate cuts could be too slow to prevent inflation from hitting zero. Evidence against this hypothesis is that deflation is a much more fearsome enemy than inflation, so the Fed will likely become alarmed and act with 50bp or 75bp cuts if inflation started falling below zero, even if it is only short term data showing a deflation risk. 

[Financial.Velociraptor]

I think it's reasonable to conclude the March rate cut is in jeopardy with GDP growth at an annualized 3.3% rate, but the market went the opposite way. Stocks rose, bond yields fell, and the Fedwatch tool actually INCREASED the odds of a March rate cut today.
 

So I did my undergrad in Econ (BBA) and I have lots of tools to (theoretically) model what is happening.  But if you get out of the weeds, the 10k foot view is "people are effin nuts!"  And that is sort of the Achilles Heel of conventional economic thought.  There is an underlying assumption that people, at least when you look at aggregate behavior, are "perfectly rational".  But the people who make up the aggregate are the same ones who make the Kardashians and thing and buy all those 9 dollar lattes. 

I wish there was a good blog from a group of Behavioral Economists who use "big math" to model what people actually do instead of idealized humans are expected to do if you assume they are perfect.  I switched to Finance in grad school b/c I couldn't cope with the cognitive dissonance inherent in the 'perfectly rational' assumption.

And that doesn't even begin to scratch the surface of how we counter intuitive group think that makes "good news - bad news".  Such as blowout GDP is somehow mightily concerning to economists...

[MrGreen]

At the present moment, I can't imagine what economists would look at as a reason to cut rates. Unemployment is near record lows. Jobs are being added at a moderate pace. GDP is up moderately. Consumer spending is solid. Mortgage rates have moderated a bit. If you forgot about what has happened recently (pandemic, supply constraints, ultra low interest rates, etc) and just looked at the snapshot of where the economy is right now, you'd say, "I'm not very happy with housing inflation but for everything else, we're in the butter zone." I would think cutting rates in this environment risks a resurgence of inflation because if mortgage rates come down there is going to be a spending party.

[achvfi]

At the present moment, I can't imagine what economists would look at as a reason to cut rates. Unemployment is near record lows. Jobs are being added at a moderate pace. GDP is up moderately. Consumer spending is solid. Mortgage rates have moderated a bit. If you forgot about what has happened recently (pandemic, supply constraints, ultra low interest rates, etc) and just looked at the snapshot of where the economy is right now, you'd say, "I'm not very happy with housing inflation but for everything else, we're in the butter zone." I would think cutting rates in this environment risks a resurgence of inflation because if mortgage rates come down there is going to be a spending party.

I agree, What is the reasoning for fed will cut rates in next few months?.. I mean while there are layoffs in some sectors like IT, unemployment is at record lows. Inflation still approaching the target and close to it. Fed funds rate is at normal level if you exclude last 15 years. Economy is at a healthy place, I don't see any reason why they would cut rates.

 

[ChpBstrd]

I think it's reasonable to conclude the March rate cut is in jeopardy with GDP growth at an annualized 3.3% rate, but the market went the opposite way. Stocks rose, bond yields fell, and the Fedwatch tool actually INCREASED the odds of a March rate cut today.
 

So I did my undergrad in Econ (BBA) and I have lots of tools to (theoretically) model what is happening.  But if you get out of the weeds, the 10k foot view is "people are effin nuts!"  And that is sort of the Achilles Heel of conventional economic thought. 

People may be nuts with their consumption, fashion, and entertainment choices, but in the investment world there is a harsh evolutionary knife constantly cutting away the influence of investors who make choices with bad outcomes. So we can only wave away investor reactions and call them irrational to a certain extent, as the price-setters have held or traded their way to riches.

The simplest logical rationale might be that it doesn't matter whether rates come down slowly or quickly. The perceived fact that they are coming down sometime within the next couple of years is enough to keep two to thirty year treasury rates low. Low longer-term yields will keep corporate borrowing costs reasonable for the next couple of years, and means the expected future earnings of stocks can be discounted at lower rates.

Whether the FFR gets cut to 4% in 12 months or 24 may be immaterial to corporate earnings if BBB companies can still borrow at 2-5 year timeframes for less than 6%, if falling mortgage rates mean the popping of the housing bubble is postponed, if the inflation of a couple years ago means S&P500 profit margins can stay high at around 10%, and if GDP growth is exceeding all expectations due to the brunt of inflation control being done by QT.

I expect the FFR/10y yield curve to remain inverted for the next 12 months, but that's in a bullish way because it means the borrowing costs and discount rates that matter are not going sky high. Investors will continue to expect rate cuts even if their timeframe is proven wrong, and so they'll continue to demand longer-term yield even if we have zero rate cuts by July.

At the present moment, I can't imagine what economists would look at as a reason to cut rates. Unemployment is near record lows. Jobs are being added at a moderate pace. GDP is up moderately. Consumer spending is solid. Mortgage rates have moderated a bit. If you forgot about what has happened recently (pandemic, supply constraints, ultra low interest rates, etc) and just looked at the snapshot of where the economy is right now, you'd say, "I'm not very happy with housing inflation but for everything else, we're in the butter zone." I would think cutting rates in this environment risks a resurgence of inflation because if mortgage rates come down there is going to be a spending party.

Counterpoints are a rapidly rising real rate of interest and an accelerating fall of inflation that raises the risk of undershooting if policy stays restrictive for much longer.  In the six months between May and November 2023, Core PCE increased 0.93%. I.e. if the Fed went from a restrictive to neutral policy tomorrow, we'd probably land at a core inflation rate below their 2% target.

But they can't reverse policy tomorrow. They have to telegraph their intentions for months, see enough overwhelming data to convince the hawkish holdouts, and then get started with 0.25% cuts every month or two. To land at a 4% FFR upper limit would take six Fed meetings at that pace, which is 7-10 months due to months when no meeting occurs. That's the timeframe AFTER they get started, which markets expect to be 2-4 months from now. Similarly, a QT taper-down might be announced near mid-year, and could conclude by December. The Fed was about 9 months behind the curve when they reversed QE in 2021.

So restrictive policy is a big ship, and bringing it to a stop will take all year unless the economy somehow completely collapses and 0.5% or 0.75% rate cuts start happening. The Fed "should" be thinking about this, and JPow has commented about reversing policy before hitting 2% Core CPI, but there are no guarantees.

[ChpBstrd]

December 2023 PCE:

PCE, annualized:           +2.6%
Core PCE, annualized:   +2.9%

Annualized Core PCE fell by -0.8% from August to December. Where will it be by the March 20 FOMC meeting? 

I suspect the market will be disappointed next week if the FOMC meeting minutes do not describe explicit rate cutting plans and a taper-down of QT. Such an outcome would be a signal the Fed is going to under-shoot, and that too-low inflation will be a problem later this year.

[EscapeVelocity2020]

I don't see a strong impetus for the Fed to cut rates in the first half of 2024.  They have a goldilocks scenario, inflation still running a tad bit hot (allowing Powell to hide behind the 2% target inflation rate) and all the numbers coming in are strong - low unemployment, high spending, moderate wage growth, strong GDP...  Cutting too soon and having inflation start to move up is just as bad as waiting a little too long and having below 2% inflation, especially since the Fed has proven the effectiveness of QE.  In the meantime they can slowly unwind QT.

Stock markets are at all time highs and loads of money is sitting in money markets, satisfied with 5%, so cutting too quickly could send stocks soaring.  Good for the rich but further exacerbates the gap between the rich and poor, which does get a lot of jawboning from the Fed.  In Jerome's perfect world, we'd maintain this strong capital market while also having low unemployment and strong-ish wage growth, while also hitting 2% inflation, which points to maintaining the status quo unless some trends begin to reverse.  At least direction-wise, I'm expecting clear signaling from the Fed that rates will remain higher for longer.

[ChpBstrd]

Thinking more about the possibility of too-low inflation:

Companies in 2022-2023 were experiencing an environment where inverted yield curves meant their long-term debts were still relatively cheap, with yields on BBB bonds rarely exceeding 6%, compared to a 3-5% range during the 20-teens. At the same time, prices for their products were increasing at a 4-9% annual rate.

Let's apply a simple merchant metaphor for illustration: It made sense for companies to borrow money at 5-6% to order products or build productive capacity when the prices they could obtain for those products was also going up at 5-6%. I.e. if I order a bunch of product to be delivered to me and sold next year, and I pay with money borrowed at 5%, then my interest expenses are completely reimbursed by the 5% higher price I can sell these products for a year from now. This is how inflation equal to borrowing rates can stimulate the supply side.

Now we need to think about a world where the merchant above still has to pay maybe 5% for debt, but lacks the tailwind of inflation to increase the prices they can obtain. If I buy product with 5% debt and by the time I sell it prices have only risen 2%, then I experienced -3% margin between my debt and my price inflation. If inflation goes to 1%, 0%, or negative, things get much worse for the merchant.

This is the risk of the Fed falling behind the curve and leaving real rates too high for too long.

[reeshau]

We still have two relatively high historical Core PCE readings to lap, so we should be in the mid-2% range by March, although not quite by the March Fed meeting.

[Financial.Velociraptor]

Rents cooling (depending on where you  live) - https://finance.yahoo.com/news/rents-will-continue-to-fall-due-to-a-lot-of-supply-in-the-pipeline-economist-says-183929627.html

So, much has been said in this thread and others about how housing is the main driver of inflation at this point.  If there really is say 6 figures a month of multi-family units coming online in the next few months this does a lot to balance supply/demand.  I know from local water board meetings that if there is plot of land anywhere in Harris County at least an acre and not in the flood plane, it is probably under contract for housing.  A whole new subdivision is going up next to me plus 2 "for sure" multi-family projects, and 1 more "maybe".  That would end construction in my jurisdiction as there would be nothing left out of flood plane and put the water plant within a few units of capacity.

[sayonara]

PTF

[MrGreen]

At least direction-wise, I'm expecting clear signaling from the Fed that rates will remain higher for longer.

Powell has been saying this for quite a while now and people are still underestimating just how long he means they may need to be higher. Hell, he's even said people are discounting how long rates need to be higher for. The only thing left for him to say is "I told you so."

[EscapeVelocity2020]

At least direction-wise, I'm expecting clear signaling from the Fed that rates will remain higher for longer.

Powell has been saying this for quite a while now and people are still underestimating just how long he means they may need to be higher. Hell, he's even said people are discounting how long rates need to be higher for. The only thing left for him to say is "I told you so."

Maybe he’ll slap someone at the next Q&A when they ask how soon rates are going to get cut! Oh maybe he’ll be like my high schooler and complain that nobody’s listening to him 😀

[reeshau]

Next Q&A:

[EverythingisNew]

I read an article recently that questioned: what if there is no landing? What if the Fed lowers rates and we hang on to 3-4% inflation.

Another thought I’ve had is that a lot of our current inflation may be generational. The baby boomers are a bubble generation and they are just now retiring in mass. They want to celebrate with trips and big lifestyle changes like buying a new house or boat. I remember when I was a kid in the early 90s my grandpa retired to a wedding style big family party, they moved to a new house in a different area, and bought an RV. It was a blowout year! If they retire to medical issues, boomers are also spending big on healthcare and conveniences to make their life easier in old age. My parents are spending big here.

It might be hard to depress the economy in the next 5 years with this cash heavy generation wanting to YOLO their retirement. After they pass away or quiet down into old age, then I see a flood of housing, classic cars, boats and RVs hitting the market and the millennial rent/don’t own generation might have some deflation in order to absorb the excess.

[reeshau]

The 6 month Core PCE is already below 2%, annualized.  Not to belabor the point, but the annual rates are hanging out because past rises were so large.  A drop is as predictable, as the sudden rise was a shock.

[MustacheAndaHalf]

Of the four largest economies, the United States has the healthiest demographics.  Other countries have more serious challenges balancing retired people and workers.  It looks like inflation driven by imbalanced demographics are a greater problem outside the U.S. :
https://en.wikipedia.org/wiki/Demographics_of_the_United_States
https://en.wikipedia.org/wiki/Demographics_of_China
https://en.wikipedia.org/wiki/Demographics_of_Germany
https://en.wikipedia.org/wiki/Demographics_of_Japan

"four largest" because India's billion citizens heavily skew younger, towards working age.  One could argue India's demographics are the best out of the top five economies.
https://en.wikipedia.org/wiki/Demographics_of_India

[ChpBstrd]

Summary of interesting points about JPow's news conference:
1) JPow explained that economic growth is still strong despite restrictive policy because of post-COVID supply chain and labor market recovery. I.e. that's his rationale for why rate hikes haven't reduced activity as much as expected.
2) JPow will not be satisfied with inflation touching 2%, he wants to see a continued trend. He's not satisfied with 6 months of good data and won't be satisfied by March either.
3) A rate cut in March is not likely.
4) Balance sheet: Planned in this month to begin in-debt discussions about tapering down QT starting in March.
5) The Fed is choosing to ignore the Taylor Rule and its prescriptions for lower rates for now.

My interpretation:
Plummeting inflation is being rationalized away, just as rising inflation was rationalized away in 2021. The Fed will probably let inflation under-shoot rather than going in for a "landing" by cutting rates and QT while Core PCE is in the 2.5% range. Unexpected economic growth in 2023 is seen as an inflation threat, despite the inflation data. Relatively strong employment numbers are seen as providing downside protection, enabling the Fed to go further in burying/overkilling the inflation problem. 

Neither the reporters nor the chairman said a peep about the risk of too-low inflation or deflation, and nobody really discussed the risk of inflation falling faster than rate cuts.

Today's market response was justified.

[achvfi]

Neither the reporters nor the chairman said a peep about the risk of too-low inflation or deflation, and nobody really discussed the risk of inflation falling faster than rate cuts.

I did hear a reporter ask and JPOW talk about inflation going below 2% target, and JPOW is said it can go below for few months as it stabilizes at target range.. something like that.

[MrGreen]

Jobs report just came in at a booming 353,000. I feel like a March rate cut is off the table at this point.

[ChpBstrd]

Jobs report just came in at a booming 334,000. I feel like a March rate cut is off the table at this point.

Wage growth is also increasing again:


In theory, a high and rising real cost of overnight interest should tamp down employment and wage pressures. In reality, the most deeply inverted yield curve in decades is offering companies the option to borrow at longer duration and pay much less interest expense. So the bond market is functioning well, even shaky companies are refinancing, big ticket durable goods orders keep rising, and GDP is rising quickly.

I've spent a lot of pixels arguing that QT must be more responsible for disinflation than people think. But maybe it's also true that the Federal Funds Rate is less consequential than people think IF - and that's a big if - the yield curve is deeply inverted. You get around the FFR by just borrowing longer-term.

In this way, we can explain the current phenomenon of a potentially overheating economy after 525bp of rate hikes and strongly positive real short-term interest rates. The "connundrum" Alan Greenspan identified in 2005 continues. Now, as it was then, the bond market is probably right.

Open questions are (1) how long can the yield curve remain inverted if the Fed doesn't cut rates very much? and (2) how long can wages rise amid a labor shortage until those wages start pushing up inflation?

The futures market still thinks there's a 20.5% chance of a rate cut by the March meeting, even though JPow literally said yesterday that March would be too soon. I think the path for a cut to still happen involves more banking trouble. I've been eagerly analyzing the NYCB situation to see if it is a one-off or a sign that rising defaults could become a driver for more widespread banking trouble.

[ChpBstrd]

I've dialed back my estimated probability of a recession in 2024 (take that as a sell signal if you know my record!). However 2025 is starting to look more sketchy.

FedWatch estimates a 4.25% upper limit to the federal funds rate in December, 1.25% lower than it is now. Federal Reserve officials keep saying they won't cut rates 5 times - more like 3.
 
Annualized Core PCE is falling at a rate of 2% per year. It is currently 2.9%.

Put these factors together and we have a situation where inflation can be expected to fall faster than interest rates. This means the real rate of interest will actually increase in 2024, even though the Fed is cutting rates. In other words. policy will get MORE restrictive despite the rate cuts.

By December, according to the current disinflation trajectory and the Fed's forecasted FFR, we could be looking at a Core PCE near 1% and a FFR upper limit of 4.75%. That would be a real rate of interest of about 3.75%. For context, the real rate of interest hit 3.25% in mid-2007.

So as the real rate gets higher and therefore more restrictive, we could actually see disinflation occur faster in 2024.




Spikes in the real rate have been associated with some, but not all, recessions in the past. If the real rate goes too high, investing in treasuries becomes more attractive than more economically productive pursuits, business expansions and new orders using debt face a higher burden of profitability to be justified, and the real burden of variable rate debt rises.

In addition to tightening policy, Chinese deflation of -0.8% per year could also drag down the price of goods in the US at an even faster rate. If the unemployment rate rises, even a little bit, that could increase the rate of disinflation. Finally, another bank squeeze could further slow inflation by reducing lending.

So there are several reasons to think disinflation could continue at the 2023 rate or even faster. The Fed's projected rate cuts would leave us with an increasing real rate of interest, which could reduce demand. This could set the stage for a 2025 recession, if 2007 is any pattern.

The catch is that a rising real rate of interest should encourage lenders to lend more. The inverted yield curve could stand in the way of that happening, as markets cannot un-invert while also believing rate cuts are coming. A rising real yield only makes rate cuts more likely, so the yield curve stays inverted. Perhaps this is a spiral.

[dividendman]

Hrm... @ChpBstrd , your arguments are always convincing... however, I have to note that since this thread started you have put a high probability of recession for (late) 2022, 2023, 2024 and now 2025...

Of course you will be right eventually... but what's the point of constantly predicting a recession that's just around the corner?

I think you lucked out on buying Treasuries at the top... take the win :)

[reeshau]

Put these factors together and we have a situation where inflation can be expected to fall faster than interest rates. This means the real rate of interest will actually increase in 2024, even though the Fed is cutting rates. In other words. policy will get MORE restrictive despite the rate cuts.

I think this is the core of the Wall Street opinion that rates will have to be cut more.

Annualized Core PCE is falling at a rate of 2% per year. It is currently 2.9%.

The last 6 months, annualized, is already below 2%.

[FIPurpose]

I think by this point, the market has to admit that basically every recession signal that was ringing in 2022 failed. The yield inversions, un-inversions, LEI, etc.

Even if there is a recession within the next year, it's going to be tougher and tougher to connect it to 2022 signals. If you're signal takes 3-4 years, then honestly almost anything could be a signal for recession.

[ChpBstrd]

Hrm... @ChpBstrd , your arguments are always convincing... however, I have to note that since this thread started you have put a high probability of recession for (late) 2022, 2023, 2024 and now 2025...

Of course you will be right eventually... but what's the point of constantly predicting a recession that's just around the corner?

I think the probability of a recession was high in 2022 and 2023, but a probability is not a certainty.

Consider that in 2022 the S&P500 fell 24% and the Nasdaq fell 33% amid yield curve inversions and high inflation. Stocks are just now revisiting highs they hit in 2021. U.S. GDP went negative in the first and second quarters of 2022, sparking debate about whether a recession should have been declared by the NBER.

By 2023, China was in full deflation. Germany is expected to have suffered a 2-year recession as the Eurozone and UK hover near zero growth.

Meanwhile an international commercial and residential real estate bubble has been hovering over our heads all this time, seemingly on the verge of popping but never quite doing so (so far). Thanks to low liquidity, low unemployment, and demand for inflation hedges, residential real estate prices have not fallen back toward affordable levels for two years (so far) and thanks to the deeply inverted yield curve, CRE has spent the whole time with 5-year refinance rates at just-affordable levels.

One might say we got lucky and different sectors of the economy suffered weakness at different times instead of all at once. Thus we had a rolling series of area-specific mini recessions that never overlapped enough to bring down the whole economy.

E.g. while a banking crisis was unfolding in early 2023, job growth and aggregate demand remained strong in other areas, and the Fed quickly extinguished the flames with the BTFP. A few months later, big tech layoffs started making headlines, even as overall unemployment was falling and the stock market was on its way to erase the losses of 2022. Had commodities spiked at the same time banks were failing and corporations were laying off staff, it might have set off the real estate bomb, as occurred in 2007-2008. Luckily, the sequence of events was just off enough for each event to be manageable on its own.

So overall if the odds of recession were something like 70% or 80%, and you braced for recession in various ways for that 2 year period, did you make a mistake just because the less likely outcome happened? I'd say no; you reacted appropriately to the probabilities and information available at the time. If you sold all your stocks at the beginning of 2022, but now you think it's all-clear, you can buy the S&P500 for about the same prices available then and you can buy VB or VO for significantly less than 2 years ago. Not a bad outcome.

Put these factors together and we have a situation where inflation can be expected to fall faster than interest rates. This means the real rate of interest will actually increase in 2024, even though the Fed is cutting rates. In other words. policy will get MORE restrictive despite the rate cuts.

I think this is the core of the Wall Street opinion that rates will have to be cut more.

I hope you are wrong about this, because what the Fed should do is very different than what they will do. Wall Street should know better than to bet on what they should do. If such bets exist, they might be unwound soon.

I think by this point, the market has to admit that basically every recession signal that was ringing in 2022 failed. The yield inversions, un-inversions, LEI, etc.

Even if there is a recession within the next year, it's going to be tougher and tougher to connect it to 2022 signals. If you're signal takes 3-4 years, then honestly almost anything could be a signal for recession.

This thought was the basis for my study last month of the average times between recession signals and the start of recessions.

For example, the 10-2 yield curve has a record of predicting recessions starting between six and twenty-two months after the start of inversion. We are right now at month 22 since its first inversion in April 2022 (month 20 if you prefer to use the more definitive July 2022 dip instead of the brief touch that occurred in April 2022). So a recession could start now and not even be an outlier.

The rate hikes recession predictor extends all the way out to my arbitrary maximum of 36 months, and yet we are only on month 23.

Perhaps the lesson shouldn't be "give up on recession predictors after 20 or so months" it should be "don't expect recession predictors to work within 3-12 months". These things typically unfold on a scale of years.

[reeshau]

So overall if the odds of recession were something like 70% or 80%, and you braced for recession in various ways for that 2 year period, did you make a mistake just because the less likely outcome happened? I'd say no; you reacted appropriately to the probabilities and information available at the time. If you sold all your stocks at the beginning of 2022, but now you think it's all-clear, you can buy the S&P500 for about the same prices available then and you can buy VB or VO for significantly less than 2 years ago. Not a bad outcome.

I agree.  Calling moves out after the fact is an example of resulting.

[MustacheAndaHalf]

Much more than recession has been discussed in this thread.  Higher Fed funds rates inflicted losses on the bond market in 2022, many of which happened after this thread started.  The stock market tanked alongside the bond market.  Those drops, without recession, were still significant events.

A market drop, with or without recession, seems like the important thing for investors.  A mild recession without much market impact isn't interesting - and was included in Powell's soft landing scenario.  Most people rely on 2y/10y yield inversion to predict a recession.  According to economics papers I've browsed, 3mo/10y is a more accurate signal. I've listed both, below, for those who have a different preference.


The 2y/10y inverted in April 2022. https://fred.stlouisfed.org/series/T10Y2Y


The 3mo/10y inverted in October 2022.  https://fred.stlouisfed.org/series/T10Y3M

When the yield curve inverted in Jan 2006, the longest recession lag was 18 months.  Then as now, you could claim the delay has never been this long.  Back then, the Great Financial Crisis was the first recession with a 22 month lag.  Now that we've exceeded a 22 month lag, is recession impossible?  I don't know the answer, but it is worth considering both possibilities ("Give me a one-handed economist.  All my economists say 'on the one hand ... but on the other hand ...'" - Harry Truman)
https://www.statista.com/statistics/1087216/time-gap-between-yield-curve-inversion-and-recession/

The classic definition of recession requires U.S. GDP remain negative for two quarters in a row.  Strong U.S. GDP growth makes that unlikely for some time, and is a cause for optimism.

[ChpBstrd]

January CPI is released tomorrow morning. Commodities rose and job creation was high, so I'm expecting CPI to maybe run a little hot. The Cleveland Fed's Nowcasting site says to expect:

CPI:          +0.13%
Core CPI:  +0.32%

I'll guess +0.2% for both. Rent disinflation is about to go over the hill in terms of 12-month effects. I.e. the gap between this month's number and the 12 month-ago number is widening, which should drag down CPI and especially Core CPI.

In the meantime, I'm thinking about how stocks are priced near where they were in 2021, even though the prices they sell their goods for have increased. Companies which are able to maintain consistent margins in a world of rising prices will have their earnings rise proportional to inflation.

I wondered if there was a long-term relationship between inflation and stock prices. The first chart below is as apples-to-organges as they get, and is open to a lot of criticism. However I think it suggests a connection between the price of companies and the price of what those companies sell, a relationship which broke down at the beginning of 2022.

With 1/1/22 as our index scale, we can see that prices are about 9% higher, but the S&P500 is only about 2% higher (the chart looks the same with different CPI index scales).

Are stock prices destined to catch up with the prices of the goods they sell?

It depends on whether margins hold up. As the 2nd chart shows, it appears there is not any major problem with margins, and higher prices are feeding into the bottom line. No wonder GDP is so surprisingly high.

[reeshau]

For January CPI to go up, the monthly change would have to be higher than the August spike that killed the summer stock rally.  That would mean more than doubling the Oct-Dec average, as Jan 2023's 0.5% monthly contribution rolls off.

I expect it lower, just on a continuation if the past 3 months' trend.

[MrGreen]

CPI came in at 0.3% and Core CPI was 0.4% for the month. I'd say chances of a March rate cute are now zero.

[Paper Chaser]

CPI:


Supercore CPI:


Housing:

[ChpBstrd]

The list of major economies in recession has expanded:

Japan suffered negative GDP growth of -3.3% in the 3rd quarter of 2023, and -0.4% in the 4th quarter.

The UK suffered negative GDP growth of -0.1% in the 3rd quarter, and -0.3% in the 4th. The chatter is about how this is occurring in an election year.

And of course Germany is "on track for a two-year recession".

The Eurozone grew 0% in Q4, narrowly escaping recession as they had a -0.1% contraction in Q3. The Eurozone had previously experienced recession between 4Q2022 and 1Q2023.

It seems like the North American economies of the US, Canada, and Mexico are charging ahead despite weakness in China, Japan, and Europe. Will North America lead the rest of the world out of recession or is it a matter of time before the rest of the world drags North America into recession? FWIW, India, South Korea, and Australia seem to each be doing well.

[dividendman]

The list of major economies in recession has expanded:

Japan suffered negative GDP growth of -3.3% in the 3rd quarter of 2023, and -0.4% in the 4th quarter.

The UK suffered negative GDP growth of -0.1% in the 3rd quarter, and -0.3% in the 4th. The chatter is about how this is occurring in an election year.

And of course Germany is "on track for a two-year recession".

The Eurozone grew 0% in Q4, narrowly escaping recession as they had a -0.1% contraction in Q3. The Eurozone had previously experienced recession between 4Q2022 and 1Q2023.

It seems like the North American economies of the US, Canada, and Mexico are charging ahead despite weakness in China, Japan, and Europe. Will North America lead the rest of the world out of recession or is it a matter of time before the rest of the world drags North America into recession? FWIW, India, South Korea, and Australia seem to each be doing well.

US retail sales were down a larger than expected 0.8% in January too, maybe there is a slowdown coming.

[MustacheAndaHalf]

Former Secretary of the Treasury Larry Summers co-authored a paper that explores the gap between CPI and consumer confidence.  Apparently in the 1980s, before it was removed, borrowing costs were part of CPI.

"We show that if we make an effort to reconstruct the CPI of Okun’s era—which would have had inflation peak last year around 18%, we are able to explain 70% of the gap in consumer sentiment we saw last year. 8/N"
https://twitter.com/LHSummers/status/1762607548828360798

"The Cost of Money is Part of the Cost of Living: New Evidence on the Consumer Sentiment Anomaly"
https://www.nber.org/papers/w32163

[reeshau]

Thanks, @MustacheAndaHalf .  Really interesting perspective, since this was the method in effect during the 1970's.  Thank God the Fed didn't have to raise rates to 20% to tame it.

[ChpBstrd]

The problem with including the cost of borrowing money in inflation statistics is the risk of getting a false signal about the effects of monetary policy.

E.g.
In a particular year, prices are increasing 10% and rates are 1%. If borrowing costs are included in our inflation stat, maybe inflation is significantly less than 10% and the Fed fails to grasp the severity of the inflation problem.

E.g.#2
In another particular year, prices are increasing 1% but rates are 10%. If borrowing costs are included in our inflation stat, maybe the Fed acts as if prices are rising much slower than 10% and fails to grasp the urgency of loosening policy.

How many of the Fed-induced recessions prior to 1983 could be explained this way?

Of course, if borrowing costs were included in CPI/PCE, we would soon be looking at new ex-borrowing versions of these statistics so that we could talk about prices. Imagine a "Core PCE Minus Borrowing" statistic.

I still think change in prices of goods and services is the textbook definition of inflation; we just have periods of lower and higher real interest rates that make it more or less economical to finance big purchases like cars, businesses, and houses.

Today's real and nominal rates may be the highest since 2007, but they are low in a 40+ year context. Thus I am unpersuaded by the argument that consumer sentiment is low because of high real rates. I think it's low because we just exited a multi-year period in which prices increased faster than wages, and that trend only reversed in May. Living standards have not yet returned to pre-pandemic levels.

[FIPurpose]

I'm skeptical of their theory.
1. Because these people are a bit more invested than the average American to want to see the cost of money come down.
2. We didn't see consumer sentiment improve when the cost of money was nearly free.
3. They mention it briefly in the paper, but high mortgage rates are abandoned as soon as rates come down and people hold on to low rates making them stickier.

They don't mention the possibility of selection bias, just randomly adding in new numbers to make today's numbers make more sense. I think consumer sentiment makes more sense in light of social reasons, not financial ones. Anxiety over global warming, war, social media echo chambers. I would've liked them to compare their theory against a few other metrics as at least a control, they only use some "trust in government" metric which feels like a checkbox that they did some comparison.

We all know the conservative guys that regularly complain about the economy, but when you ask for specifics suddenly they can't really point to anything except maybe mortgage rates or the 3 months when egg prices were high last year. They're doing fine financially, politically charged language is just training people to be negative on the economy. I would've liked to see more comparison around this.

[Paper Chaser]

We all know the conservative guys that regularly complain about the economy, but when you ask for specifics suddenly they can't really point to anything except maybe mortgage rates or the 3 months when egg prices were high last year. They're doing fine financially, politically charged language is just training people to be negative on the economy. I would've liked to see more comparison around this.

This was from the latest University of Michigan Consumer Sentiment poll, and seems related:


There are shifts in sentiment depending on which party is in charge, and whether that aligns with your politics or not. Both parties show this tendency to flip flop based on leadership, but Republicans seem to swing more extremely in their sentiment than Dems.

[ChpBstrd]

January annualized PCE:              2.6%
January annualized Core PCE:      2.9%

[FIPurpose]

One more extreme than the other meaning that conservatives apparently swing 3x more based on political sport teams vs Dems. That pretty strongly correlates it being a more social sentiment than based in hard economic realities.

[ChpBstrd]

One more extreme than the other meaning that conservatives apparently swing 3x more based on political sport teams vs Dems. That pretty strongly correlates it being a more social sentiment than based in hard economic realities.

Perhaps conservatives are more likely to be high earners with businesses or stocks, which are highly / visibly sensitive to little economic changes, whereas liberals are more likely to be service sector wage earners who do not see the impacts of financial news on their incomes.

[FIPurpose]

One more extreme than the other meaning that conservatives apparently swing 3x more based on political sport teams vs Dems. That pretty strongly correlates it being a more social sentiment than based in hard economic realities.

Perhaps conservatives are more likely to be high earners with businesses or stocks, which are highly / visibly sensitive to little economic changes, whereas liberals are more likely to be service sector wage earners who do not see the impacts of financial news on their incomes.

Maybe, but I'd expect those people to be happy about the current stock market.

[ChpBstrd]

One more extreme than the other meaning that conservatives apparently swing 3x more based on political sport teams vs Dems. That pretty strongly correlates it being a more social sentiment than based in hard economic realities.

Perhaps conservatives are more likely to be high earners with businesses or stocks, which are highly / visibly sensitive to little economic changes, whereas liberals are more likely to be service sector wage earners who do not see the impacts of financial news on their incomes.

Maybe, but I'd expect those people to be happy about the current stock market.

Unless they're not in the stock market, because Biden won the election. If they shifted into bonds in 2021... well, I'd be bummed too. And from that position they'd be inclined to believe "This can't last because Democrats are bad for the economy. Big correction coming."

[Paper Chaser]

One more extreme than the other meaning that conservatives apparently swing 3x more based on political sport teams vs Dems. That pretty strongly correlates it being a more social sentiment than based in hard economic realities.

Perhaps conservatives are more likely to be high earners with businesses or stocks, which are highly / visibly sensitive to little economic changes, whereas liberals are more likely to be service sector wage earners who do not see the impacts of financial news on their incomes.

In my circle, they're more likely to be small business owners than white collar high earners. These people tend to invest in their business and/or pay down debt rather than investing in the stock market. They have pretty good understanding of material/input costs, labor costs, and demand for their product/services. Much more Main Street economy than Wall Street economy.

[MustacheAndaHalf]

E.g.
In a particular year, prices are increasing 10% and rates are 1%. If borrowing costs are included in our inflation stat, maybe inflation is significantly less than 10% and the Fed fails to grasp the severity of the inflation problem.

E.g.#2
In another particular year, prices are increasing 1% but rates are 10%. If borrowing costs are included in our inflation stat, maybe the Fed acts as if prices are rising much slower than 10% and fails to grasp the urgency of loosening policy.

Did these scenarios ever occur?

In that first scenario, I could borrow at 1% then buy commodities that increase at 10%, and profit off inflation.

[MustacheAndaHalf]

They don't mention the possibility of selection bias, just randomly adding in new numbers to make today's numbers make more sense. I think consumer sentiment makes more sense in light of social reasons, not financial ones. Anxiety over global warming, war, social media echo chambers. I would've liked them to compare their theory against a few other metrics as at least a control, they only use some "trust in government" metric which feels like a checkbox that they did some comparison.

We all know the conservative guys that regularly complain about the economy, but when you ask for specifics suddenly they can't really point to anything except maybe mortgage rates or the 3 months when egg prices were high last year. They're doing fine financially, politically charged language is just training people to be negative on the economy. I would've liked to see more comparison around this.

I've seen graphs comparing Democrats and Republicans, and they flip when the Presidency flips.  It seems like the high side of consumer confidence reflects who controls the White House.  That said, the average does reflect changing economic conditions, taking severe drops during the Covid pandemic, for one.

If charged language is a big factor in consumer sentiment, shouldn't it be trending downwards every year for the past decade?  That isn't what I've seen, but maybe I'm misinterpreting what you said.