Is the Fed Right or the Market?

The signal and the noise

Markets were clearly not prepared for the hawkish stance of the Federal Reserve. During Powell’s press conference on Wednesday, risk assets fell hard. They continued to fall for the rest of the week. By Friday’s closing auction, the SPY had lost four percent. Why did markets fail to anticipate the Fed’s stance? What does the FOMC know that investors and market commentators do not?

The FOMC and markets both saw the BLS CPI release on Tuesday. The slowdown was anticipated by markets with risk assets rising handsomely on Monday. The sanguine view of ‘immaculate disinflation’ seemed to be confirmed by the numbers. The volatile headline fell to 1.2% in November, down from 5.3% in October on an annualized month-on-month basis. The following table shows that food, shelter, energy and services inflation all tempered in November. Markets inferred, quite reasonably, that the disinflation would allow the Fed to relax. But the Fed was not in the same place.

The FOMC’s economic projections showed that the committee had revised its expectations on the downside. The median participant’s expectation of next year’s PCE inflation was revised up from 2.8% to 3.1%, while core PCE was revised up from 3.1% to 3.5%. The FOMC now expects that unemployment will have to rise to 4.6% instead of 4.4%, while expected real GDP growth in 2023 was revised drastically downward from 1.2% to 0.5%. Markets are yet to fully price-in this quite gloomy forecast for the American economy from the technocrats.

The heart of the matter is that the FOMC believes that the happy inflation numbers released this week are largely a statistical mirage; that markets have been fooled by randomness; that ultimately it will take a lot of monetary tightening to achieve price stability. The Fed’s vassals in Europe quickly came to the same conclusion — as if they had any choice in the matter.

But why does the FOMC believe that things are worse than they look on the inflation front? Matt Klein, who seemed to be a card-carrying member of Team Transitory for far too long, has changed his mind. He points to services inflation as the key to understanding the stance of the Powell Fed.

Sure enough, whether we strip out energy or shelter, services inflation has hardly tempered. But why should the Fed care so much about a third of economy when disinflation is otherwise so pronounced? There are two theories here. The Fed’s theory, in Klein’s telling, is that services inflation, largely a function of wage growth, is still to too high because the labor market is so tight. Klein’s theory is that robust wage growth means that demand growth is likely to remain excessive. In either case, the logic here is that of wages as “super-core inflation”. Unless that is tempered, disinflation won’t happen on a sustained basis.

Powell focused on rising wages as an input cost for these services, whereas I would put more emphasis on wage growth as the main financing source that supports additional spending and gives businesses breathing room to raise prices.

Matt Klein, December 16, 2022.

Indeed, wage growth does predict inflation, although we’re very far indeed from the wage-price spiral that obtained in the 1970s, as can be seen in the following graph of rolling elasticity of next quarter’s core PCE inflation against blue-collar wage growth.

Is the Fed then at risk of falling back on old ways of thinking about inflation, which led it to irresponsibly fight tight markets in anticipation of inflation instead of fighting inflation itself? Certainly, some of the noises coming from the Powell Fed are consistent with such an intellectual regression. But even if that is the case, we’re still far from a policy error of the sort that was routine during the high neoliberal era, 1996-2008. This is because, as we shall see, underlying inflation is still robust. The upshot is that even a “New Empiricist” Fed would be doing the same thing.

I’ve argued previously that the lowest volatility quintile of the inflation series contains an extremely strong signal of the inflation expectations of the slowest-moving price-setters who have a strong incentive to pay attention to expected inflation when they set prices for their products. This is a robust measure of underlying inflation with a very high signal-to-noise ratio. By this measure, the persistent component of inflation has hardly tempered at all.

In fact, on an year-on-year basis, the lowest volatility quintile ticked up in November, from 6.0% to 6.1%. Even on a month-on-month basis, it fell from 5.3% to 5.2% — well above July’s dead cat bounce.

The following table shows the readings. The basic point is that — on an year-on-year basis, which has the highest signal-to-noise ratio — underlying inflation is still rising. Far from being close to getting the job done, the Fed is staring at an uphill battle in the war on inflation.

My claim is not that the FOMC pays attention to the Policy Tensor’s signal. Instead, my claim is tensorial; ie, independent of coordinate descriptions. The FOMC is paying very careful attention to a multitude of factors that condition the future trajectory of inflation. If it does its job competently, it should uncover something virtually indistinguishable from our signal. In other words, even if they don’t observe this signal, they should arrive at the same conclusion.

And that conclusion is indeed gloomy. Markets have been fooled by randomness. There may be a lot more tightening in the pipeline than is priced in atm.