Is Inflation Playing “Chicken” with the Fed?

Last month (in your August issue) I boiled down the Fed-speak from Jay Powell’s Jackson Hole speech in August:  

“The Fed isn’t planning on hiking interest rates anytime soon, but they are trying to prepare investors for a less accommodative Fed.”

That was the general message Chairman Powell was trying to push. However, I further warned:

“If the Fed stops buying assets later this year and begins raising rates in late 2022, the pieces will be in place for the current bull market to stall out and potentially transition to a cyclical bear market shortly after.

And the severity of any bear market will depend on the pace of rate hikes, economic growth, and whether inflation is under control.”

What would force them to start raising interest rates?

Inflation. 

It’s made the Fed an unwilling participant in a game of financial “chicken.” 

Powell continues to insist that the current surge in inflation will cool on its own once the effects of the pandemic lockdowns resolve themselves. But what happens if it doesn’t? 

Let’s talk about that this week…

Playing Chicken with Inflation

The only problem with the Fed’s projections of inflation being transitory is that reality doesn’t seem to bear them out. Let’s take a look at some recent reporting…

Last week, the Producer Price Index (PPI) came in 0.1% above expectations at 0.7% month-over-month pushing the increase in prices to 8.3% since August last year. Core PPI (producer prices that exclude food and energy costs) pushed prices 6.7% higher since 2020.

This week, the Consumer Price Index (CPI) proved to be a little friendlier — coming in just below forecasts — at 0.3%. Still, year-over-year prices are at some pretty disturbing levels if you’re the Fed. Prices are up 5.3% and core prices are up 4% from a year ago — well above the Fed’s usual inflation target of 2%.

In between those reports, there were some other pretty significant inflationary warnings…

The Fed’s Beige Book (data collected from businesses, market experts etc. from the Fed’s various districts) was released last week as well. It also revealed potential trouble where prices were concerned:

“Inflation was reported to be steady at an elevated pace, as half of the Districts characterized the pace of price increases as strong, while half described it as moderate. With pervasive resource shortages, input price pressures continued to be widespread. … Even at greatly increased prices, many businesses reported having trouble sourcing key inputs. Some Districts reported that businesses are finding it easier to pass along more cost increases through higher prices. Several Districts indicated that businesses anticipate significant hikes in their selling prices in the months ahead.”

And industry chimed in as well.

Gary Millerchip, CFO of Kroger, one of the largest supermarket chains in the U.S., recently predicted that grocery prices were going to head even higher as inflation continues to build.

Coming from the manufacturing sector, 3M CFO Monish Patowala warned about “worst-case (inflation) scenarios” that are taking hold in the market.

Even everyday Americans participating in the NY Fed’s Survey of Consumer Expectations are anticipating inflation will be a problem.

Clearly this is all a little less optimistic about inflation than the Fed’s outlook.

The only way for the Fed to get inflation under control is to tighten monetary policy (by raising interest rates.)  And raising rates — a threat the Fed has been trying to downplay into some distant future as much as possible — offers some serious downside of its own.

The (Other) Danger: Rising Interest Rates

The stock and the bond markets have always maintained an inverse relationship. Interest rates rise, and money gets pulled out of stocks.That’s because capital always goes where it gets paid the most.

Twenty years ago, when the markets were more normalized, it was a simple fact of life. 

But since the crash of 2008, the implementation of zero interest rate policy and the creative invention of “quantitative easing,” the stock market has become extremely interest rate sensitive.

And that poses another problem for the Fed. Let’s look at a recent example…

The last time the Fed decided it wanted to “normalize” interest rates (i.e. raise them back to some realistic levels) was back in December 2015/January2016. Starting in October of 2015, from an irresistible Fed Funds rate of 0.07% they started pushing rates higher.

By January 2016 funds had reached 0.36% where they stayed for most of the year. The initial push caused a dip in the stock market (circled in the chart below) which stabilized after the funds rate leveled off. Then at the end of 2016, they started steadily increasing rates again.

The stock market continued to rally in the face of these rate increases until late 2018 when  (accompanied by a yield increase to 3.23% on the US 10-Year Treasury Note) it decided that rates had risen high enough…

Stocks dumped over 20% in a matter of months.

True to form, the Fed began easing again allowing the market to make one more new high before the COVID-19 lockdown crash hit.

So…

This example is meant to show that these days there’s a super-sensitive link between interest rates and stocks. At the “frothy” levels stocks are trading at today, downside from an interest rate increase could actually be even more dramatic. (There’s a lot of money in stocks that could be looking to reallocate in a hurry.)

So the question is really, how much inflation is the Fed willing to impose on the public before it’s forced to take action?  

Or put another way, “Who’ll blink first in this game of chicken?”

If inflation “blinks” — if it starts to pull back as the Fed expects — the Fed can keep rates near zero and all will be well for a while longer. 

If, on the other hand, inflation proves to be sticky rather than transitory, the Fed may have to blink. That means raising rates to get inflation under control. (If they don’t, they risk an even worse scenario called stagflation — rising prices combined with high unemployment and a sluggish economy.)

Once they do, it’s anyone’s guess how much they can tighten before they trigger a market collapse. (The Fed certainly has no clue.) 

We’ll watch these developments closely…

Make the trend your friend,

Bob Byrne
Co-founder, Streetlight Equity