The risk of catastrophic success
The first risk is the risk of catastrophic success. The June core CPI came in at 4.9%. What if it were to fall, say, another 1% by year-end?
Consider what the consensus expectations are for the Fed Funds rate. A quarter-point rate increase is baked-in for the July FOMC meeting. The market expects no more hikes and probable cuts in early to mid-2024.
From a policy perspective, the Fed’s tightening policy relies on falling inflation to do most of the heavy lifting. If it were to hold rates steady for several months and the inflation rate falls, the real Fed Funds rate rises, which amounts to a de facto tightening. If core CPI declines 1% by year-end, the real Fed Funds rate would rise to about 1.5%. Can the economy cope with real rates at that level without going into recession?
The last mile inflation problem
While some strategists have turned bullish in response to falling inflation, others have worried about the so-called last-mile inflation problem. One prominent macro voice in the last-mile camp is Bridgewater Co-CIO Bob Prince, who voiced his concerns in an FT interview.
“Inflation has come down but it is still too high, and it is probably going to level out where it is — we’re likely to be stuck around this level of inflation,” Prince said. “The big risk right now is that you get a bounce in energy prices when wages are still strong”, which could drive a rebound in inflation, he added.
Prince believes the Fed’s policy levers are too blunt to achieve its objectives.
“Current levels of spending are being financed by income, not a credit expansion,” Prince said. “So inflation is really hard to bring down.”
In a separate Bloomberg podcast that was taped before the FT interview, Bridgewater co-CIO Greg Jensen echoed Prince’s remarks and laid out a scenario of disappointing growth and upside surprises in inflation. Such an environment would be unfriendly to both stocks and bonds.
Another key component of the inflation rate is shelter. Apartment List tracks rents, which leads the Owners Equivalent Rent component of CPI. The Apartment List Rent Index has been falling on a year-over-year basis, which is a positive sign for disinflation.
However, the analysis of monthly changes in the same data series shows that deflationary effects of rents are behind us and rents have been rising for several consecutive months. All else being equal, base effects will see the shelter component of inflation stabilize and rise again in the near future.
What about the recession?
A third risk is the risk of an imminent recession. New Deal democrat, who monitors the economy using the discipline of coincident, short-leading and long-leading indicators, recently pushed back against the soft-landing narrative in his weekly update. The bad news is a recession appears imminent. The good news is any slowdown should be relatively shallow.
- The high-frequency weekly indicators suggest that a recession is imminent, with all three primary systems indicating a near-term economic downturn.
- Consumer spending and tax withholding are of particular importance; both consumer spending measures (Redbook and OpenTable) were negative this week, and if tax withholding turns negative as well it would signal the start of a contraction.
- However, the continued improvement in the short-leading indicators suggests that any recession is likely to be either short or not very deep.
Since the publication of that note, the weekly Redbook series printed a second consecutive year-over-year reading indicating a weakening consumer.
NDD has argued that consumer spending leads employment. However, initial jobless claims improved last week and the year-over-year increase in the 4-week average fell below the 12.5% recession warning mark after five consecutive weeks of recessionary warning conditions. This is a noisy data series. Is this a data blip?