At this point, I feel like we're living in some kind of weird paradox where the obvious seems so shocking when stated aloud. Inflation is now running so hot that policy makers either do not know what to do next or have thrown up their hands. Either way, we're living in interesting times. The inspiration for this week's analogy comes from a rediscovery of one of my favorite bands and their early music - U2.
The band got a little techno later in their careers, which isn't my style of music, but their albums leading up to "Achtung Baby" were revolutionary. Their most successful album, "The Joshua Tree," still holds the record for the album to reach 1 million copies sold in the shortest amount of time from date of release. A great hit from that album is "Where The Streets Have No Name." The song was thought to have been written about Bono's trip to Ethiopia, where the streets literally had no name - just numbers. Instead, the song was actually describing the situation in Northern Ireland where cities were divided. You could tell a lot about a person then by which street they lived on - their religion, social status, etc. That is the case today as policy makers are far removed from the struggles of the common working man/woman and seem to be lost as how to handle everyday issues.
Here's what we're seeing so far this week...
What Does Inflation Mean To You? Last week's release of the Consumer Price Index sent markets for a loop as it was the 9th time in the last 11 releases that analysts had underestimated the number. The prevailing concern was that the number would cause the Fed to raise rates more aggressively. Tuesday, we learned that the Producer Price Index, another measure of inflation, didn't increase by the 0.5% expected, but by more than double (+1.0%) in January. How could analysts be that wrong? On top of that, St. Louis Federal Reserve President told CNBC, "Real wages are declining. People are unhappy." Oh, really?!
Did you need to double-check your statistics to make sure of that? Those making the policies are so far removed from the people for whom they are making policies that it's comical (see previous blog post from November, 2021). James Bullard makes nearly $200,000 per year as the St. Louis Fed President. In addition, he is the honorary professor of economics at Washington University and sits on several boards, which ticks his earnings up to about $340,000 per year. His estimated net worth is almost impossible to find in a Google search, but it's not unreasonable to think that it's north of $1 million. Regardless, as the chart above shows, for someone like Bullard, the effects of inflation are tolerable (68% in that income bracket see inflation causing "no hardship" on their personal finances). Yet, for those making much less than Bullard, the hardship of inflation is "severe" to "moderate" for 56% of those making $40k to $99k and 66% for those making less than $40k. Maybe when inflation reaches +10% (year-over-year) policy makers earning more than $100,000 will pay more attention. To his credit, Bullard is calling for the Fed to ramp up interest rate hikes 1% by July 1st - albeit too late. However, he also admits that the Fed has been "surprised" by the rise in inflation. Even Bank of America has stated that the Fed is "desperately behind-the-curve" in fighting inflation.
What's A Consumer To Do? As I have been saying for months now, consumers will begin making personal spending choices that will affect US GDP. Lately, we've been getting conflicting evidence of consumer spending. Wednesday morning, Retail Sales for January rebounded in a big way. Retail Sales had declined by 1.9% in December, and that number was revised even lower this week to -2.5%.
Yet, January's number came in at +3.8%, more than doubling month-over-month. However, a closer examination shows that two of the largest increases among rising categories was Restaurants/Bars and Gasoline Stations. Part of this has to do with COVID restrictions ending in key demographic areas in the North, Midwest, and West leading to more economic activity. However, part also has to do with rising inflation - gas & food, specifically. Perhaps another portion coming from consumers drowning their sorrows over inflation in bars across the country, if the Retail Sales report is correct. On Tuesday, the White House was still trying to claim credit for gas prices decreasing 10 cents in December.
Of course, since then, gas prices have risen 8.6% (or, $0.28 per gallon). In fact, the average price of gas has increased to the point where it stands at nearly 9-year highs. Another example of the lack of understanding from policy makers to the financial situation of lower-income earners. (BTW, Jen Psaki's salary as WH Press Secretary is approximately $183,000 annually and her estimated net worth is $2 mil). Think Russia and/or OPEC have any incentive to increase oil production? As we previously mentioned, the price of oil had been below or well below $80 per barrel from November, 2014 until October of last year. In fact, OPEC President Jean-Richard Itoua stated Wednesday that OPEC does not see any "immediate solution" to high oil prices. With oil prices above $90/barrel and rising, Russia has a major bargaining chip in its number one natural resource and OPEC is busy reaping the profits. It doesn't appear that either has much cause for increasing oil production. Maybe that Keystone Pipeline project would have come in handy right about now?
How High Can Inflation Go & When Will It Affect Markets? The answer to that question is obviously difficult to answer. However, in the short-term, we can glean some insight from the historical difference between PPI and CPI. Currently, PPI is running at +9.7% year-over-year, while CPI is at +7.5% (YoY). In the past 74 years, PPI increased and surpassed CPI in 14 different time periods. In those periods, it took CPI 21 months on average to catch up to PPI.
The average peak in the difference between the two inflation measurements in those periods equates to 5.1%. We are 13 months into the current period where PPI is running hotter than CPI. The difference appears to have peaked back in October, but eventually CPI will catch up. Most importantly, recessions occurred during 6 of the 14 periods referenced. That doesn't provide enough evidence that a recession will result this time. Yet, until we see a peak in PPI, which did result in all of the 14 time periods, we can reasonably assume that CPI will be headed higher as it catches up to PPI. When PPI peaks, it is likely that CPI will peak along with PPI. So, the long-and-short for consumers is that they need to get ready for at least 200 basis points of higher inflation for now until the data changes.
We can also glean some clue about the future of markets from interest rates. As the Fed raises interest rates, it tends to do so too late and recessions typically result. Since 1955, of the last 9 recessions, 8 resulted from a rising Fed Funds Rate cycle. The only exception being the 1990 Recession, in which the Fed had previously lowered the Fed Funds Rate.
In addition, I have omitted the 2020 recession as that was clearly not an economic-based recession but a pandemic-based recession so I'm treating it as an outlier. I think it's safe to say that once the Fed begins raising rates, a recession is very likely. On average, once the Fed begins a rate hiking cycle, a recession results within 28 months. The shortest period of time between the beginning of a rate hiking cycle and a recession is 11 months (1981 Recession). Given that the current Fed Funds Rate is at 0-0.25%, it could take some time for the economy to slow down, especially with the amount of stimulus that has been spread through the economy. The 1981 Recession saw the Fed Funds Effective Rate already at more than 9% when the rate hiking began, so an unusually short period like '81 is not as likely this time around given the low level of the Fed Funds Rate currently.
The minutes from the Fed's January meeting were released Wednesday with nothing of note in the minutes, so the market did seem caught off guard. Rather, equities rallied on the release. The market has priced in a 71% chance of the Fed raising 50 bps in March.
The Fed continued to be vague about the timing and speed of quantitative tightening, although the minutes showed that "participants generally noted that current economic and financial conditions would likely warrant a faster pace of balance sheet runoff than during the period of balance sheet reduction from 2017 to 2019." If the Fed were to slow walk tightening, we could be set up for an asset bubble that would be painful in its bursting. If the Fed tightens with haste and too aggressively, I could be writing in several months about another of U2's early hits, "Sunday Bloody Sunday." The Fed is definitely in a precarious situation.