Winning isn’t everything, it’s the only thing, according to the sports cliché. But now, just beating expectations seems to be enough to declare victory.
A company tops earnings estimates after management lowers its guidance; “Great quarter,” analysts cheer on the conference call. Your team is beaten by less than the point spread; you collect on your wager. Your political party loses fewer seats than predicted in congressional midterms, but likely surrenders control of at least one chamber; it’s a win, crow the party’s leaders.
And if inflation runs a bit cooler than economists’ forecasts, but still at a multiple of what the Federal Reserve deems acceptable, markets go into a bullish frenzy. Bonds and stocks rally massively, as investors conclude that the Fed could be close to ending its aggressive interest-rate increases because inflation is subsiding quickly from its recent four-decade high.
But analyses of current price pressures and the history of inflation cycles suggest otherwise.
News this past week that the consumer price index for October climbed less than economists had forecast spurred a huge rally. Overall prices at the retail level increased 0.4% last month, while “core inflation,” which excludes food and energy costs, rose 0.3%. Both increases were 0.2 of a percentage point less than forecast. Compared with its level a year earlier, total CPI was up 7.8%, short of the 7.9% forecast and September’s 8.2%. Core CPI was up 6.3% in October, year over year. That was shy of the 6.5% consensus estimate and September’s 6.6%.
There has been some progress in slowing the jump in prices of goods, write Mizuho economists Alex Pelle and Steven Ricchiuto in a research report. While supply-chain problems and sharply higher commodities tabs, especially for energy, have lifted global inflation, they argue that the inflation problem in the U.S. is a result of excess demand, not just supply. The Fed still has a lot of work to do to rein in consumer spending, the pair conclude.
The markets reacted to the CPI data by significantly reducing their expectations of future increases in the central bank’s federal-funds target rates.
On Thursday, following the release of the CPI report, the fed-funds futures market priced in an 85% probability that the key policy rate will rise by 50 basis points—a half-percentage point—at the December Federal Open Market Committee meeting, according to the CME FedWatch tool.
A week earlier, the futures reckoned that it was a coin flip between 50 basis points or 75—the number by which the central bank had boosted rates at the past four FOMC meetings.
The new, lower expectation for a fed-funds target range of 4.25%-4.50% next month squares with the median year-end estimate in the Fed panel’s most recent Summary of Economic Projections, released in September.
The Fed and the markets alike anticipate inflation pressures abating significantly in 2023. However, history is not on their side, according to a paper from Rob Arnott, Research Affiliates founder and chairman, and Omid Shakernia, a partner at the firm who heads its multi-asset strategies.
They find that when year-over-year inflation rises above 8%, as has happened with the CPI this year, it doesn’t recede quickly but tends to accelerate 70% of the time, based on data from 14 advanced economies dating back to January 1970. That doesn’t mean inflation necessarily will hit new highs in coming months. But, given the previous consensus that price pressures would be transitory, they write, “we dismiss that possibility at our peril.”
The real problem is that when inflation crosses the 8% threshold, it becomes more intransigent and requires more restrictive monetary policy for a longer period, Arnott and Shakernia contend. Given that U.S. inflation has run above 6% for the past year and over 8% for the seven months through September (before dipping to 7.8% in October), history indicates that the median time it will take before inflation eases below 3% is 10 years. That’s not a typo.
The exuberance with which stocks and bonds greeted the latest CPI reading indicates that they’re dismissing history. The Fed evidently is, too.
According to the FOMC’s latest Summary of Economic Projections, its median expectation is for its main inflation gauge, the personal-consumption expenditures deflator, to be running at a 5.4% annual rate by the end of this year, down from the 6.2% in the 12 months through September. (The PCE tends to move less than the more widely watched CPI for various technical reasons.)
From there, the committee’s median projections are for the PCE deflator to drift down to 2.8% by the end of 2023, 2.3% by year-end 2024, and to the Fed’s 2% target by the end of 2025. At the same time, the projections show, unemployment will move up only modestly, to 4.4% in 2023 and 2024, versus the 3.8% anticipated at the end of this year.
The bond market also appears sanguine about inflation. The “break-even inflation rate”—the difference between the nominal yield on Treasury notes and the yield on comparable Treasury inflation-protected securities, or TIPS, has moved lower in recent months. As the chart above shows, the markets earlier this year were expecting the consumer price index to average about 3.5% over the coming five years. That’s now slid below 2.5%.
These benign expectations seem to reflect undue complacency, Arnott writes in an email: “While it is entirely possible that inflation will dissipate in 2023, the other end of the possible spectrum—that inflation persists for a decade—is no less likely. That’s the basic problem.”
A decade extends far beyond any economist’s or policy maker’s prediction horizon. In practical terms, investors looking out five years can choose between a five-year Treasury yielding 3.94%, or a five-year TIPS offering 1.45%, plus the annual increase in the CPI.
Do you believe inflation will average under 2.5% for the next five years? The latest University of Michigan consumer survey, released Friday, finds that five-year inflation expectations rose, not fell, to a five-month high of 3%, from the previous month’s 2.9%. If you agree, “take the over” and buy TIPS to hedge against the markets’ great expectations that inflation will melt away.
Write to Randall W. Forsyth at randall.forsyth@barrons.com
Read the full article here
Discussion about this post