Did Powell Slay The Inflation Dragon?

Inflation is falling and falling faster than most are willing to believe.
 
The current inflation reading is 6.6%.  As citizens, we know that current inflation is still too high.  As investors, we are focused on the rate of change in inflation over the next six months.  Not where it is today.  Not where it was in the past.
 
Let’s focus on forward looking metrics.
 
One forward looking measurement is the quarter-over-quarter annualized inflation.  Instead of year-over-year, we measure the quarter-over-quarter increase, and we multiply it by 4 to get an annual number.  Based on the Cleveland Fed data below, CPI is already at 3.1%, while other measures are rapidly falling below 5%.
 
Chart 1 – Quarter over Quarter Annualized Inflation
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Source – Cleveland Federal Reserve
 
What about sticky Rent inflation?
 
While rent inflation is high and sticky, it has a substantial lag.  Remember, as investors we want to be forward looking.  Most market-based rent metrics are showing a rapid decline in actual rents.  Even Fed Chair Jay Powell admitted to the lagging effect of rent inflation and is focused on real time data.  Therefore, instead of 8% reading in the most recent report, the real-time reading is closer to 4% as shown in the chart 2.
 
Chart 2 – Actual Rent Inflation and New Tenant Rent Estimat

Source – Guggenheim Investments
 
Sticky CPI ex rent at 2%
 A three-month annualized estimate is the leading-edge inflation estimate.  To calculate this estimate, we look at month-over-month inflation for the past three months and multiply it by 4 for an annual number. 
 
Atlanta Fed Sticky CPI is a weighed basket of items that change prices relatively slowly.  However – sticky CPI excluding rent (we know rent lags) – is almost at 2%.  See chart 3.
 
Chart 3 – Atlanta Fed Sticky CPI (white) and Sticky CPI ex rent (blue)

Source – Bloomberg
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CPI Projections
 
The Fed missed the inflation call in 2021.  To ensure that inflation isn’t entrenched, Chair Powell is willing to keep rates high until inflation gets closer to the 2% mandate. 
 
In December, month-over-month CPI decreased by -0.1%.  If we were to keep that constant, year-over-year inflation will reach the Feds goal of 2% by April 2023.  If we assume a month over month growth of 0.2% for the sake of conservatism, CPI will be under 2% by June of 2023.   I’ll let you make your own assumptions.
 
Chart 4 - Projections for CP

Source – Bespoke Research
 
What does this mean for interest rates?
 
Fed has a dual mandate: 1) inflation and 2) employment.  Employment is still very strong because jobs are easy to get.  Therefore, the Fed is laser focused on inflation.  Historically, once the Fed funds rate moves above year-over-year CPI, the Fed knows they are fully in control.  While we aren’t there yet (chart 5), based on the projections in chart 4, we know Fed will be well in control starting March 2023.
 
Chart 5 – Fed Funds Rate and CPI

Source – Federal Reserve of St Louis
 
What Are the Risks?
While positive for growth, the base case impact of China reopening and stimulative policy is for the dollar to weaken, and for commodities to rise.  This could reverse some components of declining inflation.
 
Goods prices have collapsed over the past year.  They will not keep falling at the same rate.    They may even rise and offset the deflationary impact in other areas. 
 
Are We There Yet?  What does it mean for the Fed?
 
If history was a guide, the Fed would already be cutting interest rates.  However, a once in a century pandemic and stimulus has changed the current calculus.  Fed is more focused on inflation, and less on growth.  Given the rapidly declining inflation, we are likely in the 9th inning of this rate increase cycle. 
 
The aftereffects of interest rate increases are felt with a lag.  While job layoff announcements have risen, jobs are still easy to find.  Starting in 2Q, unemployment claims will increase.  With inflation well under control, Fed will likely focus on employment, its other mandate.  The first step will be to announce a pause in rate hikes.  Usually, rate cuts follow in six months.  Post WW2, Fed has cut interest rates by 3% after a pause, and to a larger extent in the past two decades.
 
Chart 6 – Historical Rate Cuts

Source – Fidelity
 
What does this mean for the market?  Stay tuned.


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