Inflation response lags Federal Reserve moves

Investment Analysis Clubs Macro Economic Trends and Risks
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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.

Wonking Out: It’s a Lagged, Lagged, Lagged, Lagged World

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.

5-Year Breakeven Inflation Rate (T5YIE) | FRED | St. Louis Fed = 2.62%.
5-Year, 5-Year Forward Inflation Expectation Rate (T5YIFR) | FRED | St. Louis Fed = 2.40%.

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.

Wendy

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None of the above…monetary policy wont work.

Fiscal policy will work in curbing inflation.

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Thing is, the interest rate cure does not seem to be getting any traction, yet. GDP up, after two quarters of decline. Employment strong. Inflation strong. Outside of a few isolated places, like housing, no impact of policy. What are the chances the Fed’s interest rate increases will be “bigger than expected”? And what are the chances of Mr Market panicking the other way, again?

Steve

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Remember that the entire Treasury yield curve currently has a negative real return UNLESS inflation drops to under 4%. That means that borrowers are still being PAID to borrow – by definition, stimulative.

That implies that the Fed will have to raise rates if inflation doesn’t fall as predicted since they want to become restrictive for a while and eventually taper to neutral.

If they raise the fed funds rate to 2% above the current rate of inflation (that would be 8%, which is not extreme by historic standards) the stock and bond markets would both tank, big time.
Wendy

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The recent runup in the market was attributed to chatter than the FED was going to reduce the rate of rate increases. Seems Mr Market has set himself up to have his whip sawed, again.

A chunk of those gains came Friday, when the Dow rallied more than 700 points, while the S&P 500 and Nasdaq each popped around 2.3%. Investors reacted to corporate earnings and a Wall Street Journal report showing some Fed officials were concerned over interest rate hikes going too far.

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“Interest rate cure . . . no traction”. 70% of gdp is consumer driven. We know they responded to rising costs by spending saving and now by running up credit cards. The spending slow down is getting here after some delay.

So far mostly the slowdown seems to be businesses anticipating slowing business. The effects of higher rates are still ahead except maybe in new homes.

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During this entire thing there will not be a recession worth writing home about.

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Beg to differ. “Housing” is 20% of GDP, and that’s off significantly - at least in the forward facing stats (starts). Closings are also off, but not as much, and price increases have moderated in most geographies.

“Housing” also has carry-on effects as when people move they buy furniture, hire painters (or do it themselves), do landscaping, etc. That’s estimated to be as much as another 10% of GDP - JUST from housing.

Rent increases are also slowing. But that’s another that takes a long time to play out, because the contracts are typically a year or more, so some of the increases won’t happen for another 10 months or whatever.

Energy prices have come back down, but except for your own personal gas tank, those cost decreases won’t show up until the entire production cycle sees them: from raw materials extraction to transport to assembly to transport to retail. It can take months, sometimes a year for that to show up.

Lumber is down. Steel is down. Other commodities are down: grains, even chicken and eggs. Also moderating: used car prices and other things that took the rocket ship ride for no apparent reason lately (crypto, art, tech stocks, etc.)

I’m not saying “it’s over”, but to paraphrase Winnie Churchill, maybe it’s not the beginning of the end, but perhaps this is the end of the beginning. Or something like that.

Of course the Fed could continue on its backward looking jihad and crash everything, an outcome I sort of expect as they try to atone for their earlier negligence.

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How is even less inventory, from fewer houses being built and fewer resales hitting the market, going to lower housing prices? Not everyone has the luxury of staying where they are. Yes, the rate of increase has slowed, and there are many sellers who set their prices too high during insane ramp up in pricing that are now having to lower their prices, but no bargains.

Home prices in our area are projected to increase 4.5% next year. Yes, rents increases have slowed, but 20% annual increases were not sustainable and we are back to 5-7% as the norm for lease renewals and 10% for tenant turnovers. Demand remains MUCH higher than supply. We now have a commuter bus that brings workers from an hour away so that they can get to work and have a place to live in the boonies that they can afford.

If home owners believe that they will be stuck in their homes for some time to come, those who didn’t already do so when stuck at home for Covid will take steps to make the property more attractive to themselves. This spending will continue or possibly increase with DIY. I expect contractors to have less work, however, though that may be wishful thinking as we have some projects we would like to get done but getting a contractor is impossible.

The market is ignoring the Fed, as are the general population who continues to spend a lot. Used car prices, like homes, may be coming down a bit, but much of that is no doubt due to the 17% used car loan interest rate. That rate caught Youngest’s eye pretty strongly, to the point where he went on YouTube and figured out how to replace his alternator on his 2010 Hyundai with 250,000 miles, rather than replace it.

More rate hikes in our future until the Fed sees less spending and less rebound mania from the market. I expect two more 0.75 hikes, and who knows from there. Fed credibility is being challenged and they will not slow down until they can point to data that shows they should.

IP

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It’s not going to “lower” housing prices. It’s stopped the inflationary upward ascent of housing price increases. Nobody expects prices to come down to 2019 prices unless there’s a severe crash in the housing market, which I don’t see being predicted anywhere.

Of course. But during the pandemic there was a lot of “unnecessary” moving, i.e. people flipping houses in the same area. People who are transferred for work will continue to be transferred for work. People who don’t “need” to won’t. Less demand. Less change. Lower increases, and in many cases, actual decreases (I’m already seeing plenty in this market, but acknowledge not all markets are the same.)

Yeah, well that’s kind of the point. When you say “rent increases have slowed”, that doesn’t mean “rents have gone down” It doesn’t mean “rents are stable.” It means those inflationary rent increases have slowed.

Not historically how it works. A hot housing market begets more, not less renovation. When the housing market cools, expect better service from contractors. Always has been, don’t see why it wouldn’t be true again.

You sound like you’re having a violent agreement with me. The Fed’s policies have already demonstrated they’re working. Used car sales is just one data point.

It’s working, contrary to those who say “it’s not” and point to housing prices being higher than 3 years ago. Well, duh.

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Your first quote was implying that housing was already no longer contributing to a rising inflation. Perhaps it would be clearer had you stated that the increase in prices has slowed, rather than “off significantly.”

There was also a lot of people staying put rather than move, such as the elderly who would have gone to a retirement home, but no longer trust institutional living. With housing being so expensive, people who would have to buy a new place realized they would be simply paying lots of transaction fees for a place that was less affordable. Our area saw investors realizing profits, usually bought up by other investors looking for profit. People are still not adding to available inventory which is what is going to increasingly keep housing prices high and rising.

A hot housing market means you can sell your house without property inspection, leaving the renovation to the buyers. A cold housing market means that you had better have your house move in ready if you are putting it on the market. And yes, as I stated I sure do hope there are more contractors available as we are prepping our house for sale in 2024 and have some projects we would rather not have to YouTube. It’s been impossible to get someone out for basic things. I would rather not do a bedroom addition myself.

If it’s working, it’s too slowly for the Fed to stop raising rates. And my point on housing was prices are higher this year than last and will be higher next year than this year. Don’t know how you reached the conclusion that my reference point was 3 years ago.

We shall see. You be you and invest your money how you see fit. For now I am just picking up individual stocks and staying largely in cash until time to throw it into index funds. We are not there yet, IMO. Enough time spent on this. Am off to spend money.

IP

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