Too high for too long? – The Fed could rethink

Outlook: Today, the calendar includes the prices of imports and exports, the Empire manufacturing index and industrial production. Canada reports the August CPI. Oil could be a priority as gas prices have skyrocketed in Europe and US inventories are now expected to show a decline. Italy has gone so far as to cap prices.

The market is torn between concern over the slowdown in China and rising inflation in the West, although the UK’s 3% isn’t exactly a barn burner. Canada is now reporting the CPI, which is expected to be higher at 3.9%, which would be the highest since March 2003. The core should increase by much less so that the BoC can stick to its rhetoric of transitory inflation.

The main idea is that the inflationary effects of the pandemic subside at any time (i.e. the Fed is right that most price hikes are transient), but we say the inflation is not so easily pushed back and besides, who says the pandemic is behind us? Note that commodity prices did not get this message and are higher again today.

Market consensus on the CPI report: all is well and the Fed is still on a long, very long term before raising rates. Admittedly, US inflation has been a little lower than expected, especially in the core, leading some to believe that the Fed was justified and that inflation is only transitory. Therefore, the tapering announcement may take place during the November FOMC (with a good hint in September), but actual rate hikes are still postponed until the end of 2022 and 2023.

We were surprised by the reaction to the inflation report — the Treasury bills and the falling dollar. Perhaps we were too influenced by the NY Fed’s Inflation Expectations Report on Monday. This shows that the expectations for the key categories are much higher than what we have today (5.3% yoy in August). In fact, it’s more like 7-9%.

As for the “inflation mentality,” think about housing. The CPI does not measure shelter costs correctly. Its “owner’s rent equivalent” measure rose 2.6% year-on-year in August, beating Case-Shiller (19%) and the NAR report (23%). This is because the BLS asks people what they think their house might go for if they rented it while other metrics are based on actual sales. Housing is about a third of the total CPI, so hold that down, hold that down. But real people know their homes have grown and grown a lot over the past year – they can easily check it out on Zillow and other sites. It’s the only type of inflation homeowners like, but it’s still inflation that is not measured and reported by the government, which cannot be good for public confidence.

A small minority see housing this way too. Bloomberg reports that fund manager Jeffrey Gundlach said that if the inflation statistics “used real house prices rather than the equivalent rent from owners, the CPI would rise 12% year over year.” Gundlach takes issue with “the idea that the current peak will be temporary and has said that inflation-protected Treasury securities look” quite expensive “compared to current levels.”

Equally important, we need to question the Fed narrative that it is only a small number of goods and services that determine the CPI, and many of them are linked to the pandemic. But shelter, food, gasoline and medical care are not a small number of possessions. They are practically the whole mega-city. As for being linked to the pandemic, okay, but we have at least one case of falling prices due to the pandemic: air fares. Besides, who said the pandemic would be over in 6 months or a year?

Financial professionals admit that the Fed is willing to let inflation spike a bit in order to bring the average closer to 2%, as the 2% target has long been exceeded and is starting to look pretty silly. It only makes sense if you fail to consider how humans make decisions. People don’t consider prices only increased 1% last year, so 3% this year is good because the average is 2%. Instead, they panic thinking that over the next year the cost of renting a house / apartment will increase by 10%, gasoline by 9.2%, food from 7.9% and healthcare 9.7%, especially when they think their salary / salary increase will only be 2.5% and not up to the mark. This is what the New York Fed investigation revealed on Monday and it certainly points to an “inflation mentality” that is already stalking the country. Equally important, it is much more than “getting a little hot”. It’s on fire.

It is also a forecast and not a reality. But consider the second problem, the set of supply problems causing at least part of this inflation. The Atlanta Fed’s corporate inflation expectations are pretty low, with unit costs expected up to 3.3% on average, but that’s the August report. Unit costs are terribly messy because unit labor costs are what we tend to focus on and for material supplies we are kind of stuck with the prices of inputs to the producer. This is neither realistic nor representative because obviously not all growers use all inputs, but the August PPI was up 8.3% (and we don’t have an update until the 14th). October).

So quickly pick a series of inflation numbers going forward that would meet the Fed’s criteria of “hot but not on fire”. How about an average of 3.5-4.5% but no more for the remaining four months of the year to start declining in January. Is it realistic?

Where does the respite in commodity prices come from, let alone the Central Thing, microchips? One answer is the end of the rebuilding cycle. We searched high and low and found no expert on this topic. Take cars. Yesterday’s data showed a drop in those famous used car prices but an increase in new car prices. This involves an inventory of used cars. How long does it take for dealers to recognize that they can’t get away with higher prices? Presumably the availability of cars that are no longer new next year will have something to do with it, but with the chip shortage and production cuts new cars are only more expensive and people will hang on to them for longer. , depriving the guys of used cars. You can be hopelessly entangled in these projections.

Conclusion: We say the Fed is deflating as the evolution of data and expectations point to an increase in the inflationary mood. Inflation will likely exceed the 3.5-4.5% range without fire.

The CME federal funds tool does not yet show which players buy into the inflation story – you have to wait until the December 2022 meeting for expectations of a rate change to come true – but wait. The probability is not zero that this expectation increases. Until when ? Well, let’s say March-April. March saw the first inflation above 2% (2.6%) and April is when it started to grow bananas (4.2%). By next March / April, inflation will have largely exceeded the 2% target for a full year. Someone is sure to notice. We like the comment from the WSJ reporter: “By the time the tapering is complete, the risk is that the Fed is no longer wondering whether it should start raising rates, but how much it should raise them. “

If and when this idea takes hold, the dollar comes back. We are likely to be haunted by this demon until all the data is available. This is, of course, a minority viewpoint and also too far into the future to be useful in making trading / hedging decisions today. But keep it in mind. What is the likelihood of a Fed review on the basis of too high inflation for too long? Between 30 and 50%. But the scenario may derail IF commodity prices decline, the supply situation improves and inventory rebuilding accelerates. Note that we are not naming the demand side of the inflation story. This means that we assume that employment picks up and wage increases continue, so that consumers fulfill their manifest destiny of shopping.

For now, we have declining yields and a weak dollar which represents something akin to confidence in the Fed and its stance on inflation. Fed economists are among the best in the world. (We’d love to get a glimpse of their calculations.) Maybe the thing we should be anticipating is when the Fed recognizes that inflation is not that easy to control and we should expect numbers. higher longer. This implies an earlier cut so that the Fed can continue rate hikes. At the end of the day, we’re not buying the story of consensus today and it’s scary.


This is an excerpt from “The Rockefeller Morning Briefing”, which is much larger (about 10 pages). The Briefing has been published daily for over 25 years and represents experienced analysis and insight. The report offers in-depth information and is not intended to guide FX trading. Rockefeller produces other reports (spot and forward) for trading purposes.

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About Robert Valdivia

Robert Valdivia

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