Some wanted to jump the gun and declare victory for Team Transitory. Not so fast, says the data. The idea that last month’s respite signaled peak inflation was always more hope than evidence-based reasoning. Robert Armstrong has the right idea — high inflation also means more volatile inflation and more uncertainty regarding the path of inflation. It’ll take a lot more before the FOMC can be sure that we’ve turned a corner, and even then, they may not want to slacken the pace until there’s been substantial progress towards the overriding goal of monetary policy — price stability. A dovish pivot by the Fed will have to wait on dispositive evidence that inflation is falling back to target.
The Fed really, really cares about inflation expectations because of the central lesson of the Seventies — once expectations get deanchored, it can be very painful to bring them back down again. Much better to keep them contained in a tight box around the target.
Breakeven inflation, which capture the inflation expectations of bond traders, were threatening to get destabilized in the immediate aftermath of Putin’s invasion of Ukraine. That’s now priced out; traders’ expectations have fallen back to levels consistent with the Fed’s mandate. Consumer inflation expectations have also restabilized. So far so good.
However, for the purposes of monetary policymaking, what really matters is the inflation expectations of price-setters. These are hard to get at. We have argued previously that this information can be extracted directly from the detailed price series. Specifically, we argued that the lowest volatility quintile of the price series corresponds to the inflation expectations of the slowest moving price-setters who, precisely because they set prices infrequently, must pay careful attention to where inflation is going and set their prices accordingly. In other words, the lowest volatility quintile contains a strong expectations signal that can help us get a handle on inflation expectations most relevant to monetary policymaking. We have reason to believe that the Fed has also begun paying attention to this signal.
Last month I reported that our expectations signal had stabilized at 5.4% per annum in July. The respite was short-lived. The August reading came in at 5.6% per annum.
This is consistent with the evidence from other robust measures of underlying inflation. Note that core inflation is much more volatile than median inflation or trimmed mean inflation, both reported by the Cleveland Fed. Of the measures reported by them, the least volatile is median CPI, which increased by 0.7% in August, up from 0.5% in July. Our measure is even less volatile than median CPI. On a month-on-month basis, our measure clocked in at 0.5% in August, up from 0.3% in July.
The following table shows the year-on-year prints for the same measures since January 2021, when, by our measure, expectations were bang on target. Worryingly, our expectations signal has been rising relentlessly since then. The July respite may well have been a dead cat bounce.
So, the evidence is quite compelling that broad-based price pressures are still gathering pace, and price-setters’ inflation expectations are still rising. The upshot is that the Fed cannot afford to slacken the pace of rate hikes for some time.
A number of risk factors are combining to introduce substantial uncertainty in macroeconomic projections at the present conjuncture. The most important risk is that further inflationary shocks may yet emerge from the Russo-Western confrontation. We don’t know how this game of Mercy will unfold. Much will depend on whether Europe is able to withstand the gas weapon without major instability that would call into question the bloc’s ability to withstand the Kremlin’s pressure. The members of the bloc have announced a combined 350bn euros in support measures. It is not clear whether that will be enough to underwrite stability on the continent this winter. There’s no compelling reason to be confident whether Europe will buckle under pressure or stand firm. It could really go either way.
On the battlefield, the Ukrainians appear to have made some progress in the east, owing to what appears to be a very successful head-fake to the south. However, it is not clear if the success of that offensive constitutes a turning point in the military struggle. Probably not. The Russians may be much harder to dislodge from southern Ukraine where they have concentrated the bulk of their mobilized strength. There is a substantial risk of a major Russian counter-offensive around Kherson. And if his position becomes more difficult, Putin may yet choose to escalate and expand the war effort; including by ordering a major mobilization — as the Russian right has increasingly begun urging loudly. Pushed to the brink, Russia could mobilize a lot more military power and bring it to bear on Ukraine, complicating the Western effort to kick Russia off the ranks of the great powers.
Putin may also escalate his economic offensive beyond gas. Recall that he’s still holding at least the oil weapon, the wheat weapon and the neon weapon in reserve. Recall also that neon is “indispensable” for chip manufacturing.
Ukraine supplies about 50 per cent of the world’s neon gas, analysts have said, a byproduct of Russia’s steel industry that is purified in the former Soviet republic and is indispensable in chip production.
Beyond the Russo-Western confrontation, there are other, more persistent risks. Manoj Pradhan and Charles Goodhart have argued that the great demographic reversal is not only a headwind for growth, as we have shown, but also for price stability. Specifically, they’ve made the compelling argument that the rapid aging of the global workforce is necessarily inflationary. As labor becomes ever scarcer, the relative price of labor will rise on a sustained basis, implying a secular buildup of wage-push inflationary pressures, in turn suggesting that the Phillips curve may be returning from the dead. Gita Gopinath has marshaled evidence that the Phillips curve may already have revived post-Covid. Specifically, she has shown that output gaps predict WEO forecast errors in 2021, suggesting a steeper Phillips curve than before the pandemic.
This observation led Maurice Obstfeld to worry about the possibility that the coordinated response of the world’s central banks to global inflation may be too much, rather than too little. It’s possible. But Obstfeld does not marshal any evidence for his case that the central banks are at risk of overtightening.
Obstfeld also does not consider possibly the main risk faced by the central banks. Namely, that unless they can successfully bring inflation down to tolerably low levels pretty soon, their credibility as inflation-fighting central banks may be compromised. It tooks a couple of decades to establish the credibility of the hard currency-issuing central banks. It cannot be squandered lightly.
So, risks abound at all policy horizons for the technocrats. However, their choices are, for now, overdetermined by their lexicographic preferences — price stability must be secured before secondary goals can be targeted. This does not guarantee a jumbo hike of a hundred basis points at the next meeting. But it most certainly means that the Fed cannot slacken the pace until dispositive evidence emerges of progress towards the overriding goal of price stability. And the evidence so far suggests that we’re very far from any reasonable goalpost. The present monetary cycle may thus have much greater amplitude and may last much longer than either markets or technocrats expect. Certainly, if we’re already in the midst of a great demographic reversal, we could be on a cusp of a secular cycle rather than on our way back to “the New Normal” of lowflation and low rates.
TLDR:
Lesson is short long bonds?