Just a Little Bit Louder Now

More thoughts on inflation and rate policy supported by a new paper on inflation targeting and housing costs

• Fed's Aggressive Rate Hikes Were A Panic: In response to crippling inflation reaching levels not seen since the early 1980s, the Federal Reserve, led by Chairman Jerome Powell, abandoned its "transitory" stance and began a series of unprecedented and aggressive rate hikes to reduce inflation despite inflation expectations remaining stable.

• Transitory Inflation Misconception: The 15-month inflation was largely driven by non-monetary factors such as the 2020 shutdowns, aggressive fiscal policy, and disruptions from Russia's invasion of Ukraine. Flexible Core CPI measures now significant disinflation and have returned to prior deflationary trends, indicating that inflation was indeed transitory.

• Housing Market and Interest Rates: The Fed's interest rate policy has remained elevated, targeting housing inflation. A new paper from the Minneapolis Fed identifies that this was counterproductive. There was a real increase in demand for housing, admittedly stoked by the Fed’s inappropriate panic in 2018. Increasing rates reduced supply and led to higher real housing prices. In response, we are beginning to see a rise in occupants per household, reversing the pandemic-driven demand for housing and ultimately creating a potential housing surplus with no change in supply rates.

• Corporate Greed and Profit Margins: During the inflation spike, corporations leveraged the opportunity to increase profit margins by incorporating a margin of safety based on prior year inflation. As inflation recedes, this practice will lead to stabilized or declining corporate profit margins, and stable prices will now appear as deflation due to past seasonal adjustments.

The Main Event

Way back in July 2022, in the midst of a Fed-driven bear market (one of very few without a recession), I wrote a post on Jay Powell’s newly found backbone, “Bringing Out the Inner Volcker.” The lead in to the extensive piece:

In the last year, the United States has grappled with crippling inflation that has risen to levels not seen since the early 1980s. The Federal Reserve, led by Chairman Jerome Powell, has been forced to discard the “transitory” language it originally adopted and begun a series of rate hikes to reduce both the level of current inflation and, more importantly, inflation expectations. The Chairman and other Federal Reserve Board members have indicated that interest rates must be hiked aggressively to reduce demand and eliminate resurgent inflation before it becomes entrenched. After over a decade of low interest rates, it seems the time has come to pay the piper.

Unfortunately, Fed actions fly in the face of their own analysis, which indicates that inflation remains transitory. Aside from the housing speculation assisted by the Fed’s aggressive presence in mortgage financing, the other drivers of inflation are not monetary policy but rather the 2020 shutdowns, aggressive fiscal policy to offset the pandemic, which facilitated a V-shaped recovery, and the unexpected disruptions associated with Russia’s invasion of Ukraine. As Jerome Powell noted in his Congressional testimony, “There’s not anything we can do about oil prices.”

Now, setting aside discussions of inflation as a change in the price level versus the price level itself for a moment, it seems clear that inflation WAS indeed transitory. Measures of FLEXIBLE Core CPI, those that rapidly capture changes in prices and had spiked to an astonishing 54% annualized by June 2021, have now fallen to the 1%ile in history — down 6.2% annualized MoM. Importantly, the disinflationary trend from 1985 continues and the central tendency is now negative:

Over the last year, these levels have remained in persistent deflation, despite the repeated calls for “tough comparisons.” We’ll return to “Why?” in a moment…

Sticky measures of inflation EX-shelter have also fallen sharply. Seasonal effects of annual rate-setting led the first few months of 2023. This is important. Excluding shelter (and even to an extent INCLUDING shelter), prices have “menu reprinting costs.” Remember, the Fed’s objective is “price stability,” not “zero inflation.” Why? Because if companies have to change their prices too frequently, PRICE becomes a primary determinant of economic activity. Goods go on sale, customers stockpile. Price hikes? Customers defer. For most goods and services, the cost of frequent price setting outweighs the benefits of constant margins. This is essentially the driver of “sticky” prices, and the “Great Moderation” was a testament to the “expectations” channel of price setting — if price changes are largely down-trending and “stable,” then seasonal factors settle into stability. This can be seen in tight downtrending channel for sticky prices ex-shelter from 2004 to 2019. Note that recent “unexpected” spikes have been in the first three months of the year:

When the price level becomes unhinged, as it did from March 2021 to June 2022 (a whopping 15 months you trans bashers), the annual price-setting process becomes a “catch-up with safety margin” — particularly if an increasingly concentrated supplier base can dictate terms with little threat from competition. This is why measures of “corporate greed” suddenly appeared. It’s not that corporations “suddenly got greedy” — it’s that they were able to get away with it for the first time in decades. Mechanically, this helps explain record corporate profit margins and ironically REINFORCES the transitory nature of the inflation we experienced. When corporations “catch up” and add a margin of safety based on prior year inflation, their profit margins are inflated in a receding inflation environment. It also leads to declining relative quantities of goods and services as their real prices rise — exactly what we’re seeing in consumer packaged goods:

As inflation recedes, and remember from last week that durable goods inflation is now the most negative since the 1930s, this price-setting adjustment will grow smaller and corporate profit margins will stabilize and potentially recede. But ironically, these STABLE prices will now show up as deflation. Why? Because the past three years of seasonal adjustments will soon take over. Remember the seasonal adjustment methodology:

Can we see this disruption in seasonality? Yes, we can. Due to the pandemic disruptions, the pattern has flipped noticeably. Instead of summer inflation adjustments for “core core” CPI that expect inflationary pressure (and hence LOWER June, July, and August), we now expect deflationary pressures. Jan/Feb/March and Oct/Nov/Dec are now expected lower (and hence adjusted higher). Sound a bit like the pattern of inflation expectations we’ve seen in the past three years?