The Federal Reserve has said that it expects inflation response to lag its interest rate raises.
That’s common sense. Consumer price inflation is due to growth in consumer demand for goods and services that grows faster than production of those goods and services.
Fiscal policy which adds or removes money directly from consumers has a direct, almost immediate impact on inflation. Monetary policy, which adjusts interest rates, has an indirect impact on consumer spending (but a direct impact on asset prices).
As investors, we need to be aware of the timing of the lags since the Fed responds to inflation reports (like yesterday’s) and that impacts our investment choices.
by Paul Krugman, The New York Times, Oct. 28, 2022
For the most part, Fed policy works through two channels: Tight money raises mortgage rates, which causes a housing slump, and it also leads to a strong dollar, which eventually makes U.S. goods less competitive on world markets…
…the negative impact of a strong dollar on the trade balance takes two years or more to fully manifest. … [chart showing this lagged effect is real]…
[ The housing category of expenditure typically accounts for over 40% of total expenditures in the CPI. ] The Bureau of Labor Statistics measures the cost of housing, which largely reflects the average amount paid by renters, which is then used to estimate an “imputed” cost for homeowners — in effect, what they would be paying if they were renting their dwellings.
This procedure makes sense for evaluating the cost of living, but it can be problematic as a way of judging the current state of the economy. Why? Because most renters have leases, so the amount they pay lags far behind the rates paid by new renters. A recent study by the B.L.S. found that this lag averages about a year… [end quote]
Compensation costs for civilian workers increased 5.0 percent for the 12-month period ending in September 2022. But once adjusted for inflation, the real value of wages has actually been falling. This is what happened in the 1970s when workers pushed for wages to keep up with inflation, causing a wage-price spiral.
Krugman writes, “So does the Fed need to do more, or has it already done too much? It’s a judgment call. There is, I’d argue, a strong case to be made that there’s considerable future disinflation already in the pipeline.”
Well, Krugman was on “Team Transitory” in 2021 (wrong, as he admits himself). He is always on the side of the optimists who want the Fed to stop tightening because inflation will somehow control itself.
The 5-Year Breakeven Inflation Rate and the 5-Year, 5-Year Forward Inflation Expectation Rate (a measure of expected inflation (on average) over the five-year period that begins five years from today – that is, from Year 5 to Year 9) are remarkably consistent and level.
Isn’t it strange how they hardly responded at all to the spike of inflation in 2022 which is ongoing?
Well, both of these series depend upon the interest rate of TIPS (which are subtracted from the regular Treasury). The TIPS market is much smaller than the Treasury market. The Fed buys about 25% of TIPS at auction. (Per the WSJ.) By buying TIPS, the Fed can adjust the interest rate to anything they want. So it would be easy to manipulate the TIPS yield to get the forward inflation expectations to whatever they want the market to believe.
But the Fed doesn’t control the BLS or the BEA. Those agencies will report the inflation as they see it, regardless of the Fed’s forecasts.
Krugman, a self-confessed “optimist” and inflation dove, predicts that the Fed’s tightening won’t begin to impact inflation for at least 1 to 2 years. That implies that the Fed will not begin to cut the fed funds rate (even if they pause raising it) for at least 1 to 2 years. Fed Chair Powell said that he expects “pain” and won’t give in to pushback until PCE inflation is brought down to the Fed’s target of 2%. (It’s currently 6.2% and not falling significantly yet.)
Whether we invest in stocks or bonds, we need to be aware that the current regime of tightening will probably stay in place for at least a year or two. That will cause zombie companies to default as many won’t be able to cover the interest as they roll over their maturing debts.
Is future deflation in the pipeline, as Krugman and Morningstar believe? Maybe. That might be a reason for a bond investor to buy regular Treasuries instead of TIPS – if they believe it.