The Shirt-Front on Team Transitory
Anyone who has played competitive football (of the contact variety) will recall the pain of being on the receiving end of a shirt front, especially if it is unanticipated. Overnight, Team Transitory and the bond market by extension, received a shirt front from the US October consumer price index. The increase of 6.2% at the headline and 4.6% (excluding food and energy) were the highest readings since the early 1990s. While that was higher than consensus, it was entirely consistent with the prices paid sub index in the ISM (chart 1) and Small Business surveys. To be fair, the lead indicators probably are near peak levels. Nevertheless, the persistent nature of the recent inflation data have undermined the credibility of Team Transitory.
The disturbing element of October’s inflation print is that two key elements of consumer price index are yet to be fully reflected in the data. The first is the shelter component (or owner occupied rent) which lags real-world housing costs. The second is the employment costs which is the more durable factor behind a potential wage-price spiral. While some of the re-opening and supply driven factors ought to ease over the coming months, a second wave could be driven by shelter costs and a self-reinforcing wage-price spiral next year. As we noted a few weeks ago, that raises a difficult decision for corporates; raise final prices or face margin compression. With S&P profit margins at a record high it suggests the risk is on the downside if inflation persists (chart 2). On the positive side, part of the reason why inflation is persistent is the underlying strength in final demand (sales revenue) as the economy re-opens.
The other key implication of the data is that it has taken the real Fed Funds policy rate to the lowest reading in history. With the upper bound of the nominal Fed funds rate at 0.25%, the “real” yield is roughly -6% that is almost 20 basis points lower than the peak policy error in the 1970s. Clearly the real policy rate has been deeply negative for some time, but the upside surprise in the October inflation has taken FOMC policy to a new low. The Fed have effectively already repeated the policy error of the pre-Volcker era.
Put differently, when the pandemic was the greatest threat facing the economy, central banks and the fiscal policy response was swift. It is clear today that the biggest threat is inflation and no longer the virus outbreaks. The low levels of inventory, supply chain breaks and rising final demand suggest that emergency policy settings are now wholly inappropriate and probably a policy mistake. The response ought to be a more rapid normalisation in rates, higher long end yields, greater fixed income volatility and by extension challenging conditions for liquidity beneficiaries (expensive, highly levered, negative free cash flow “growth” equity based on hopes and dreams). As we have often noted recently, it is a key reason why we prefer inexpensive bank equities with positive carry and correlation to higher rates. Odds are that policy normalisation expectations need to be brought forward.
Clearly there are key differences from the 1970s in terms of globalisation, technology and the disinflationary impulse from demographics. However, from our humble perch the current inflationary pulse is clearly inconsistent with emergency policy settings or the lowest real policy rate on record. Of course, when Volcker tightened in the late 1970s total debt to GDP in the United States was around 158%. Today it is 376%. The other potential contradiction is that low rates might have been a symptom of weak trend growth since 2008 rather than a gift for asset prices. A key risk as we noted above in 2022 is that highly levered entities might be vulnerable to a sharp rise in rates.