To The Moon

Beware wishful thinking about inflation and recession

Inflation has peaked. The Fed's tightening has accomplished its mission. Strong labor market and consumer fundamentals will keep any recession mild.

These are among the story lines providing a tailwind to stocks in recent weeks. They feed hopes the Federal Reserve has achieved a soft landing: bringing inflation down to 2% without pushing up unemployment or tipping the economy into recession.

A reality check is in order. A soft landing is certainly possible, but these story lines look more like wishful thinking than a tough-minded appraisal of the Fed's task. Let's review.

The inflation threat has passed. Though inflation hit a new four-decade high of 9.1% in June, market sentiment on inflation has improved markedly since early last month. The Bloomberg Commodity Index has fallen 18% from its 2022 peak, copper by 33%, lumber by 54% and Brent crude oil by 22%. Since early June expected inflation over the next five years, based on the pricing of inflation-indexed bonds, has dropped 0.4 percentage point and over the following five years by 0.5 point; both are now in the 2% to 2.5% range, near the Fed's 2% target.

So has the inflation threat passed? No. It is certainly better to have bond and commodity markets expecting inflation to go down rather than up. But the Fed has made it clear it wants to see actual inflation go down; inflation sentiment alone won't cut it.

Odds are overall inflation will decline in coming months as gasoline prices stabilize or drop and improved supply chains temper goods prices. But the question isn't whether inflation will drop below 9%, but where it settles once various supply shocks dissipate, i.e. what is the underlying trend rate of inflation? No single measure captures that trend but a decent approximation comes from the Dallas Fed's trimmed-mean personal consumption inflation index, which each month excludes the most volatile prices. It was 4% in May, double the Fed's target.

Research by the St. Louis Fed shows that raw material prices have almost no impact on this measure of underlying inflation, and for good reason: they are only a tiny share of total costs. As the price of lumber plummeted two-thirds from peak to trough last year, home prices marched steadily higher.

The Fed will shift its priority to recession from inflation. Declining commodity prices and bond yields signal softer global growth ahead. Investors extrapolate that to say: the Fed has tightened enough and will now focus on staving off recession rather than combating inflation. The Fed is your friend, so buy stocks.

That reflects a pre-2021 mind-set when inflation was usually around 2% and there was no need to force it lower by strangling the economy. Thus, a recession was always a policy error -- the result of tightening too much or easing too little. When growth weakened or the financial system seized up, the Fed could rush to the rescue by slashing rates, buying bonds, or both. Stocks then rallied. This became known as the "Fed put," named for put options which protect investors against losses.

None of that applies today. Underlying inflation is far above 2% and if it takes a recession to get it back down, that is unfortunate, but not an error. In options-speak, the Fed put is deeply out of the money.

Monetary policy is tight. By clearly signaling plans to raise short-term interest rates, the Fed has sent bond yields and mortgage rates up by the most since 1994. So monetary policy has clearly tightened. But is it actually tight, in an absolute sense? One measure of that is the real interest rate, i.e. the nominal rate minus inflation. That, however, depends on what inflation will be. You could once assume 2%, in which case today's bond yields are positive, though still historically low, and maybe the Fed is nearly done. But if future inflation is 4%, real bond yields are still negative and the Fed has work to do.

Strong fundamentals will keep any recession mild. Households' wealth is at an all-time high, they are flush with cash, and job markets are drum-tight with payrolls up a blistering 1.1 million in the past three months. Many economists and policy makers say these solid fundamentals mean if a recession happens, it will be mild.

There are two problems with this reasoning. First, the severity of a recession won't be a function of fundamentals, but the stubbornness of inflation. The Fed has to raise interest rates until demand softens enough for inflation to fall. If fundamentals are strong, that just means the Fed will have to raise rates more to achieve the desired effect on demand. In fact every time stocks rally on hopes the Fed will stop tightening, it makes the Fed more likely to keep tightening. That is because higher stock prices bolster consumer wealth and confidence and thus demand.

Second, the fundamentals may not be that strong. Inflation is eating into savings and income. And the job market may be less robust than payroll data imply. A separate survey of households shows employment has declined over the past three months. Claims for unemployment insurance are rising at a rate usually seen in recessions.

None of this is to say a soft landing won't happen. Some unusual features of the economy point in that direction. The restricted supply of goods and labor has contributed disproportionately to rising prices and loosened restrictions could do the opposite. Moderating wages could take pressure off costs. For now, though, these are just theories, and the Fed prefers reality.