Enduring Inflation

Published on June 14, 2022

Recent research shows that current inflation, adjusted for changes in methodology, is much closer to the peak of the early 1980s, casting doubt on the sufficiency of the Fed’s countermeasures

Last Friday, the Bureau of Labor Statistics reported May 2022 data for the Consumer Price Index for all urban consumers (CPI-U). The CPI-U rose by 1% in May on a seasonally adjusted basis and has risen by 8.6% over the past year, reaching levels that have not been seen in four decades. 

Federal Reserve Chairman Jerome Powell and Treasury Secretary Janet Yellen now admit that the high inflation that surfaced in 2021 was not “transitory”. Perhaps “enduring” is a better way to characterize our inflation problem?

Although most Americans who use a large portion of their income to buy food, gasoline, and housing hardly needed Friday’s data to realize that we have a very significant inflation problem, the financial media and market participants previously had more confidence in the Federal Reserve’s ability to stop galloping prices. 

That confidence now seems to be disintegrating.

Interest rates act as financial gravity, as Warren Buffett has said on several occasions. The Federal Reserve may be in its “quiet period” due to the FOMC meeting taking place today and tomorrow, but well-connected reporters are suggesting that a 75 basis point increase in the Fed Funds rate is now on the table for this meeting. Expectations for more aggressive rate hikes caused treasury yields to increase dramatically yesterday. For example, the six month treasury bill yield increased from 1.98% to 2.25% while the 2 year treasury note yield increased from 3.06% to 3.4%. 

Investors who can now earn higher risk-free rates from short-term treasuries are naturally less enthusiastic about owning riskier assets. From its record closing high of 4,796.56 on January 3, 2022, the S&P 500 has fallen to 3,735 as I type this at 4pm on June 14, a decline of 22.1% which now “officially” qualifies as a bear market. The index has declined by more than 9% over the past four trading sessions. And the decline in the S&P 500 is nothing compared to the carnage we have seen in speculative sectors of the stock market and in cryptocurrencies. 

What’s fascinating about the current state of affairs is that even the most “aggressive” projections for increases in the Fed Funds rate leave it well in negative territory in real terms if inflation remains at current elevated levels. Including this week’s FOMC meeting, there are five meetings remaining in 2022. If the FOMC hikes rates by 75 basis points at each of these meetings, which is more than market participants expect, we would end the year with a Fed Funds rate of around 4.5% which would represent a real rate of negative 4% if the CPI is still running at the pace recorded in May.

David Einhorn recently spoke about inflation at the 2022 Sohn Investment Conference and brought up the fact that the manner in which inflation is calculated has undergone significant changes in recent decades, particularly with respect to housing. The video is worth watching in its entirety, but you can go to the nine minute mark for his comments specifically related to changes in the CPI calculation:

Mr. Einhorn cited a recent paper by Larry Summers which concluded that current CPI inflation would be much closer to the peak of inflation recorded in 1980 if we were still using the pre-1983 methodology for housing. 

Larry Summers is a former Treasury Secretary and has a long history of advising Democratic presidents. He has been warning about the risk of persistent inflation for much of the past year. His paper reveals many disturbing facts that the Federal Reserve would be well advised to consider at the meeting that is currently underway.

Mr. Summers and his co-authors conclude that changes to the calculation of the housing components of the CPI that were implemented in 1983 cause a discontinuity in the CPI data series that might be fooling policy makers into thinking that current inflation is well below the peak of the early 1980s:

“This paper highlights that the way that housing inflation was measured in the CPI made previous inflationary cycles look more volatile and responsive to Fed policy. We draw two sets of conclusions. First, our observations imply that the current inflation regime is closer to that of the late 1970s than it may at first appear. In particular, the rate of CPI disinflation engineered in the Volcker-era is significantly less when measured using today’s treatment of housing. In order to return to 2 percent core CPI today, we need nearly the same 5 percentage points of disinflation that Volcker achieved.”

I recommend reading the paper in its entirety for those who are interested in the technical details of how the shift to the “owners’ equivalent rent” methodology had the effect of reducing reported CPI. What is important to emphasize is that if the current methodology for calculating housing inflation had been in place in the late 1970s and early 1980s, reported CPI would have been lower than what was reported at the time, as this graph from the paper shows:

The blue line in the graph shows officially reported inflation prior to 1983 and the red line shows inflation that would have been reported if the current methodology for calculated housing inflation had existed prior to 1983. 

“Figure 3 shows that the peak of the Volcker-era inflation (March 1980), currently understood to have been at 14.8 percent, is only 11.4 percent when adjusted for the switch from homeownership costs to OER.”

With inflation running at 8.6% in May, we are quite a bit closer to the peak inflation of March 1980, as adjusted for the change in methodology for housing. 

If Mr. Summers and his co-authors are correct, the Federal Reserve faces a much more persistent inflation problem than previously thought and will have to bring about disinflation similar to what the Volcker Fed engineered in the early 1980s. This has truly frightening implications for financial markets. The Fed Funds rate would have to rise well into positive territory in real terms, as Stanley Druckenmiller suggested in the interview I linked to in yesterday’s Weekly Digest:

“Once inflation gets above five percent, its never come down unless fed funds have gotten above the CPI. Well, since the CPI is eight, that would call for a fed funds rate of above eight, and frankly I don’t think we’ll get there because of the extent of the asset bubble and the damage that would be done.”

Exactly a year ago, when it already seemed clear that the Fed might be engaging in very wishful thinking, I wrote Pounds of Salt: The Fed’s Epistemic Arrogance.

“The point of this article is not to criticize the Federal Reserve for being wrong about the course of economic activity during a pandemic that has no historical parallel in a modern economy but to question whether the Fed is suffering from epistemic arrogance. When questioned about this, Chairman Powell seems to express some humility but his organization seems addicted to continuing to produce overly precise forecasts that everyone should know will have no bearing on reality.”

Chairman Powell was recently confirmed for a second term and has been given wide latitude by President Biden to do what is necessary to tame inflation. Although financial markets now expect a 75 basis point increase in the Fed Funds rate tomorrow, market expectations for the second half of the year seem to fall well short of what is necessary if Mr. Summers is correct.

Mr. Powell claims to be an admirer of Paul Volcker who was widely criticized for his aggressive actions during the late 1970s and early 1980s. At the start of a second four year term and with backing from the President to take strong action, Chairman Powell arguably has more political capital than Mr. Volcker had four decades ago. The question is whether he will use this political capital even if financial markets throw a tantrum in response.

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Enduring Inflation
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