Control Panel: CPI increase 9.1%

All METARs know that inflation has become a Macroeconomic problem all over the world.

The Federal Reserve has announced that they will tighten monetary conditions (raising the fed funds rate and allowing rolloff of their immense book of Treasury and mortgage bonds) to reduce inflation to their target of 2%.

(Note: Fiscal policy is controlled by the government, which can directly add or subtract money from consumers with tax policy, public spending or helicopter gifts, etc. A government which “helps” consumers afford higher-priced goods/ services by sending them money is stimulating the economy and causing more inflation. A sure sign of political, rather than macroeconomic, policy.)

Whenever bond yields are lower than the inflation rate, the REAL (inflation-adjusted) bond yield is negative. Borrowers are being paid by the lender to borrow money. This leads to speculation and widespread misallocation of capital.

So the inflation rate is very important. The Fed wants a “restrictive” rate to slow the economy, which implies positive REAL yields. The historic real yield of the 10 Year Treasury bond (10YT) was over 2% before the Fed’s massive meddling in the bond markets.

But…

The question is: what is the inflation rate?

The U.S. Bureau of Labor calculates the Consumer Price Index (CPI):
https://www.bls.gov/cpi/

**In June, the Consumer Price Index for All Urban Consumers rose 1.3 percent, seasonally adjusted, and rose 9.1 percent over the last 12 months, not seasonally adjusted.**

The Fed prefers to use the Personal Consumption Expenditures (PCE) Price Index which is calculated by the Bureau of Economic Advisors:
https://www.bea.gov/data/personal-consumption-expenditures-p…

**Change from Month One Year Ago, May 2022 = 6.3 %. The June report will be released 7/31/2022.**

The CPI and PCE Index weight prices differently and use different “hedonic adjustments.”

Using either of these indexes, the 10YT yield is still deeply negative. But the Fed reports it as positive because they use their own long-term estimate of inflation which is much lower than the actual inflation rate.
https://home.treasury.gov/resource-center/data-chart-center/…

https://fred.stlouisfed.org/series/REAINTRATREARAT10Y

According to the Fed, "The Federal Reserve Bank of Cleveland estimates the expected rate of inflation over the next 30 years along with the inflation risk premium, the real risk premium, and the real interest rate.

Their estimates are calculated with a model that uses Treasury yields, inflation data, inflation swaps, and survey-based measures of inflation expectations."

The Fed’s 10-Year Real Interest Rate in July 2022 is 1.066%. The market yield of the 10YT is 2.96%. This shows that the Fed estimates the expected rate of inflation over the next 30 years to be 2.96 minus 1.06 percent or 1.90%.

https://fred.stlouisfed.org/series/REAINTRATREARAT10Y

https://fred.stlouisfed.org/series/DGS10

The bond market’s breakeven inflation rate represents a measure of expected inflation derived from 10-Year Treasury Constant Maturity Securities (BC_10YEAR) and 10-Year Treasury Inflation-Indexed Constant Maturity Securities (TC_10YEAR). The latest value implies what market participants expect inflation to be in the next 10 years, on average. It’s 2.36%.

https://fred.stlouisfed.org/series/T10YIE

The Fed isn’t using the CPI or any other consumer inflation rate to base their moves. They are using their own long-term estimates which are far below the actual consumer inflation rate.

Economists are already worrying that the Fed will tighten too much, too fast and cause a recession.
https://www.wsj.com/articles/as-fed-tightens-economists-worr…

Similar arguments were used in the 1970s when the Fed tightened and loosened three times as stagflation squeezed and resurged relentlessly. It was only after Fed Chairman Paul Volcker decisively raised the fed funds rate above the CPI inflation rate in 1980 that inflation was quelled. The 1980-82 recession was tough, but people understood that it was necessary.

The Fed is being very cautious because an astronomical amount of debt was issued at negative real rates after 2008 and especially 2020-2022. Read the book “The Lords of Easy Money” to see how so-called “zombie” companies were loaded with debt and will default if their debt can’t be rolled over at low rates.

If the Fed suddenly raises rates to above the CPI or even the PCE inflation rate, $Trillions of bonds will crash in value. Many institutional investors (including international), pension funds, insurance companies and non-financial companies would be devastated.

I was surprised to see that the stock market had a little pop up after the CPI was announced. This was noise.

The DJIA, SPX and NASDAQ are bouncing up and down in a narrow channel. They won’t change until the Fed’s next announcement, which is expected to be a 0.75% rise in the fed funds rate next week.

VIX and financial stress are slightly elevated but stable so there’s no sign of a financial crisis.

The percent of S&P 100 stocks above their 200-day moving average and NYSE Bullish Percent are both around 25% – a bearish sign since they aren’t horrible enough to be a bottom.

Treasury yields, which peaked a month ago, have subsided and are in a channel.

The trade is neutral, neither risk-on nor risk-off. The Fear & Greed Index is in Fear, though some of the stock market metrics are in Extreme Fear.

The USD continues to strengthen. As a result, many commodity prices are falling. (Gold, silver, copper, oil, natgas, gasoline, lumber, wheat, corn.) Natgas price is beginning to rise. The copper:gold ratio (a “mungofitch indicator”) is plunging. When “Doctor Copper” falls relative to gold, the real economy is slowing. This may be a result of the real estate debt problems and slowed economy in China.

The markets are strangely stable, considering the high June inflation reading. Perhaps the fall in commodity prices and the Fed’s transparency has calmed the markets into thinking that the Fed will not continue to tighten. However, the Fed has clearly stated that they will tighten until inflation is controlled to their 2% target with a Fed funds rate of about 3.5% in 1Q2023. Possibly more to come if inflation isn’t low for at least a few months in a row.

With pressure to avoid a recession building already, we may see a repeat of the 1970s…or not. Powell admires Volcker so he may stick to his guns as he has said several times. I think that this will require rates to rise above the CPI inflation rate, not the Fed’s model long-term optimistic inflation rate.

I don’t see anything to upset the apple cart next week. The METAR is partly sunny. There may be noise up and down but no major moves.

Wendy

https://stockcharts.com/freecharts/candleglance.html?VTI,$SP…

https://www.financialresearch.gov/financial-stress-index/

https://stockcharts.com/freecharts/candleglance.html?$IRX,$U…

https://stockcharts.com/freecharts/candleglance.html?$SPX,$U…

https://stockcharts.com/freecharts/candleglance.html?$SPX,$U…

https://stockcharts.com/freecharts/yieldcurve.php

https://www.cnn.com/markets/fear-and-greed

https://stockcharts.com/freecharts/candleglance.html?$GOLD,$…

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(Note: Fiscal policy is controlled by the government, which can directly add or subtract money from consumers with tax policy, public spending or helicopter gifts, etc. A government which “helps” consumers afford higher-priced goods/ services by sending them money is stimulating the economy and causing more inflation. A sure sign of political, rather than macroeconomic, policy.)

Wendy,

You are steadfast in that opinion. In fact any instrument used monetary or fiscal to grow the US economy has a marginal release of some inflation. The idea is to use fiscal policy during this part of the cycle to grow the US economy up until only a 2% rate of inflation. That optimizes the US economy. During the supply side period the US economy was never optimized. While there was disinflation there was anemic GDP growth. Leave the country poor in the wake of supply side economics.

Currently fiscal policy is not being used to create much growth in the US economy while inflation is being brought under control. Fiscal policy is deliberate not random.

Most of today’s inflation is a result of monetary policy.

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Similar arguments were used in the 1970s

In the 1970s was a delaying of restructuring the economy to free market forces. In particular interest rates as the S&L were stymying interest rates cutting off inflation.

In the 70s cracks were showing that capitalism needed to be recapitalized. None of these things are true today.

The FED long term inflation rate seems reasonable to me. It is not worth debating.

The current management of the FF rate looks towards normalizing interest rates. The dance is to see whose toes get stepped on.

When you and I see nothing to upset the apple cart…there are black clouds on the horizon about to come out of China. Which week soon we get a catastrophe is close but unknown.

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