This article is an on-site version of our Unhedged newsletter. Sign up here to get the newsletter sent straight to your inbox every weekday
Good morning. Stocks have fallen two days in a row. It’s a correction! Or something! Whatever it is, we’re back to talking about inflation. Email us with your thoughts: firstname.lastname@example.org or email@example.com.
Prices and politics
October inflation in the US came in hot. For now, this is probably a bigger deal politically than economically, but the politics will matter to markets.
The important number from Wednesday’s consumer price index report is inflation ex-food and energy, which rose 4.6 per cent. This tells us core inflation is about as hot as it has been since June:
The July and August reports were a bit of a head fake. They made us think inflation was cooling. It is not. But it’s not really getting worse, either. Because October’s 4.6 per cent is 10 basis points higher than June’s 4.5 per cent, we can have headlines about a 30-year high in inflation again, but core inflation is roughly 4-4.5 per cent, and that’s where it’s been. Don’t freak out.
We have strong demand, fuelled by government stimulus, and supply bottlenecks which are causing price spikes, especially of goods. Some people think when those bottlenecks go away, and things will go back to normal. Other people disagree. Unhedged has no idea which side is right, but in any case is not convinced we got very much in the way of new information in yesterday’s report.
The best case for freaking out is based on the housing component of CPI, which is stable, sticky and big (a third of the index or so). It rose by 3.5 per cent, and the trend looks like this:
Part of the issue here is that houses are assets, not goods, and we are in something that looks an awful lot like an asset bubble. If you strip out owners’ equivalent rent (which reflects house prices), the picture is less bad. Plain old rent inflation is still below pre-pandemic levels:
If house prices keep going crazy, rent will eventually follow, but we are not there yet.
So we are where we were: waiting to see what happens when the bottlenecks clear (including the labour bottlenecks, which show up in things such as food away from home prices). Federal Open Market Committee members who were dovish before are unlikely to be suddenly more hawkish now. Federal Reserve chair Jay Powell has stated plainly he thinks “transitory” is compatible with inflation that doesn’t start to normalise until the second half of 2022. Team transitory can still say, “We should keep monetary and fiscal policy loose, prices will cool, higher wages will stick, and there will soon be happiness all across the land.”
But for now there is not happiness all across the land, because fuel prices are high and real wages are stagnant at best. Nominal wage growth minus inflation including food and energy (a volatile series that is not predictive, but which reflects the world people live in) looks like this:
Vulgar language is warranted here. Objectively, this sucks. If team transitory is right, the trend will reverse, perhaps dramatically, and the journey will have been worth it. But the economic debate about what kind of inflation we are seeing cannot obscure the reality — and the political reality — of that chart. Here’s a tweet from Joe Manchin, the swing vote Democrat in the Senate:
“By all accounts, the threat posed by record inflation to the American people is not ‘transitory’ and is instead getting worse. From the grocery store to the gas pump, Americans know the inflation tax is real and DC can no longer ignore the economic pain Americans feel every day.”
This is factually false. Inflation is not getting worse by all accounts. But it is accurate emotionally. It’s time to think about the market implications if President Joe Biden’s agenda is dead in the water.
Forward guidance cannot deliver on its promises
When a central bank surprises the market, the C-word starts to fly. “The Bank blinked on rates and now its credibility is on the line,” read one headline after the Bank of England held UK interest rates steady last week.
Barclays’ Moyeen Islam, writing in the FT on Monday, suggested the BoE might protect its credibility by adopting something like the Federal Reserve’s dot plot — a chart of the monetary committee’s expectations for future policy rates. The idea is this: if central banks say they are going to do something, and then do it, markets will believe them the next time they talk. This lets policymakers affect rates with talk alone — and potentially affect rates all along the yield curve, not just at the short end.
But credibility can only be a byproduct of good policy. Whatever yesterday’s guidance was, things change, and the important thing is doing the right thing today. Here’s how the former Fed economist Claudia Sahm put it to me:
“At the end of the day, credibility rests on making the right decision . . . Frankly, the Bank of England to some extent could have been blindsided by the data. Again, at the end of the day, you should do the policy you think is the best policy. If the world gives you the opportunity to be able to signal it, this is even better.”
Our colleague Martin Wolf makes the same point, in an email:
“The sensible way of thinking about this is that the central bank will actually do what it thinks sensible at the time, given its targets. Unless it is stupid, it will not do what is now obviously the wrong thing to do even if it has indicated before that it might do something else that it then thought was the right thing to do.”
There are two things a central bank really needs. A policy framework that is not only wise but clear enough that the market can roughly anticipate the actions it will dictate; and unified, consistent and persistent communication of that framework.
The US central bank has been exceptionally good at communicating its intentions lately. As a result, we seem to be tapering without a taper tantrum. This is good, and a welcome contrast with the BoE. But the Fed’s policy framework is a bit of a mess. Its average inflation targeting framework is vague. As Sahm put it: “They can’t even agree on what an average is.” This might cause trouble before long, dots or no dots.
Forward guidance might be useful as an internal reference tool. A dot plot might give individual monetary committee members a bit of autonomy, which might make them behave more responsibly. And guidance might, under certain fortunate circumstances, give central banks a bit of power to jawbone the yield curve. But it can only be a weak tool.
There will always be dissonance between central bank decisions and market expectations. Below is a chart of one-year London interbank offered rate, in blue, plotted against what one-year-hence expectations for that rate had been a year before, in orange (thanks to Edward Al-Hussainy for suggesting the chart). The two are proxies for what traders thought Fed policy would be, and what it turned out to be. Unsurprisingly, the dot plot’s introduction in 2012 did not stop people from putting bad bets on Fed behaviour:
Dots, schmots. Hedge funds are gonna hedge fund. (Ethan Wu)
One good read
Aswath Damodaran on Tesla’s valuation. He is very optimistic about the company’s future, and still thinks the stock is wildly overpriced.