Fed Chairman Jay Powell shocked the market yesterday when he implied that the final rate that the Fed hikes to will be higher than the market was thinking. At the same time, he said that they might slow down the rate of increases.
This shocked the market because they believed that the Fed would be finished tightening by March of next year at about 5%. Now they are thinking much higher, perhaps even to 6%.
The market actually believes that inflation will start to come down pretty quickly by March 2023 but take a year or so to decline to the Fed’s target of 2%.
But Jay is right and the market is wrong, from one perspective.
There are several problems:
- Inflation may come down next year but very little
- The recession will cause governments to boost transfer payment keeping inflation high
- The Fed Funds rates normally has to rise above the inflation rate to cap inflation.
Let’s take a closer look.
Some elements of inflation, such as food and energy, will likely decline as demand for those products declines as the recession gets worse. So the volatile parts of inflation will come down a little.
Only a little because we are heading into shortages of many of these commodities such as:
- Nickel
- Lithium
- Corn
- Soybeans
- Copper
- Nat gas
- Diesel
So lower but not much lower.
The one element of inflation that will come down a lot will be housing and that is an important part of housing. We already see some housing markets down 20% in price already!
But inflation will stay at a high level because:
- Rents are still increasing. The government bean counters shifted from housing prices to rental prices in their calculation of CPI a few decades ago. Rents are rising and will likely rise for another year. There is a sharp shortage of apartments and it will take about a year to build enough to cap rental prices. Declining single family house prices will eventually mean rental prices for them will also decline but, once again, it will likely take a year.
- Wages are still increasing. Fed Head Jay looks at the employment market and sees a very tight market. And that tight market is increasing nominal wages as labor has the pricing power not the businesses. Companies have the money to pay so they will continue to increase wages.
- Productivity is not increasing much. Increases in productivity reduce inflation. So the drop in productivity is inflationary. Actually, productivity is declining at about a 5% rate so that will increase inflation on the labor cost side.
- Real wages are declining. So workers will push even harder to get pay raises. Declining real wages will cause the Democrats to lose control of the Congress but it will also push workers to demand higher wages to offset the inflation. Right now, real wages are declining by about 2.5%, up from a decline of 5%. But look for more labor demands and this will boost inflation by several percent
- The current political season has put inflation front and center in people’s consciousness. The Republicans are pounding on high inflation and the Democrats are touting their Inflation Reduction Act. The point is that both parties are talking about inflation. This means that people who had not thought about it six months ago are now thinking about it. That can lead to inflationary psychology. Inflation psychology is where you go and buy something you don’t need because you will need it in the future and don’t want to pay a higher price. For example, you buy extra food at the supermarket and then store it so you don’t have to pay the higher prices down the road. I’m seeing some of that now but not at the levels I saw in the late 1970s. But here is the problem. An inflationary psychology becomes a self fulfilling prophecy because the pre-emotive buying causes an increase in demand now and that drives up prices. I look for inflationary psychology to increase through the winter.
What does this all mean?
That the Fed will have to raise interest rates higher than they and the market think to tame inflation. Frankly, what they need to do is to is raise rates above 8% to really stop inflation.
So how do we make money on this?
- The stock market is in a new bull market as they look over the current bearishness and look to the upcoming pivot next year. But the market will stagger over the near term as the Fed keeps delaying the pivot. So look for a sloppy bull market
- Bonds will decline more from their current levels to discount higher inflation and lack of a Fed pivot. Larger budget deficits will also cause an increase in Treasury bond issuance which will weigh on the marke.
- The dollar will resume its bull market as the Fed has the tightest monetary policy in the world.
- Emerging market stocks, currencies, and bonds will suffer under the regime above.
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