Good morning. I don’t think I can recall any major data release that was as expected as yesterday’s CPI report. Called yesterday to economists and strategists who are both struggling to point out in the report what is not in line with their own or consensus goals. Not sure what that means, if anything.

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As bad as we thought it was bad enough

Well, here we are:

The solid blue line is core inflation compared to a year ago and last month, excluding food and energy. The green dotted line includes all items. Annual inflation accelerated for the third straight month. Monthly growth was solid, and interestingly, headlined slightly below core as both food and energy prices fell last month (a phenomenon most observers don’t expect to continue).

As expected, cargo was the biggest driver. The shocking example remains used cars, which rose 37% from the year before, handily beating the S&P 500. This confirms my plan to liquidate my 401k and retire the proceeds of selling my 12 year old Mazda, which is currently appreciating $2.7 million by 2041.

Home prices, which everyone is watching closely because of their link to wages and their ongoing trend, are hot, but not hotter: the monthly growth rate is in line with the previous two months. But this data is lagging, and CPI rents will rise before falling. It is currently reflecting neither the sharp mid-year rent spike nor the rent cooling we’ve seen recently.

Earlier this week, I wrote panic It’s worth it when we see prices for services (except health care and transportation) rise sharply. The reason for concern is that we have a good theory for why commodity inflation might disappear. The pandemic has pushed demand from services to goods; stimulus payments mean aggregate demand has not fallen, and may even have risen; when the pandemic subsides, demand will shift to services and commodity prices will normalize.

But if strong demand and limited labor supply push wages up, and those wage increases seep into the services sector, that’s evidence that we’re heading for a huge, sticky wage-price spiral.

Well, the wage-sensitive services I warned about did accelerate in December, if not completely sharp. From haircuts to house cleaning to legal services and funerals, prices have risen more or less from November. These are volatile series and we need more confirmation of this trend. But I don’t like that at all.

This is especially concerning because real (post-inflation) wages are falling. Workers have good reason to respond to widespread price increases by demanding higher wages. Olivier Blanchard of the Peterson Institute described the problem this way in an email:

If I were a worker and I looked at 2021, I came to the conclusion that I have lost a fair amount of real income (actually, based on what I see on the prices I see on a daily basis, I think the inflation rate has gone up considerably more than 7%). The labor market is tight; it’s time to ask for a raise, or threaten to quit, or strike if there’s any kind of union. . .

This is the wage-price cycle. . . that’s where the uncertainty lies. That could force the Fed to do more than it has slowly promised to do.

As Blanchard admits, it doesn’t have to happen this way. As Strategas’ Don Rissmiller told me, there is already a wage price spiral in some low-wage sectors such as leisure and hospitality. but:

There is still a way out, especially for high-paying careers. People are demanding flexible work. They don’t want more pay, they want to work from home on Mondays and Fridays. . . it is again a pressure relief valve. There’s certainly a risk, and the biggest risk we’ve had in a while, that we’re entering some kind of wage-price cycle. But the Fed now has the potential to act and stop service-sector inflation.

How can you stop inflation with lower negative real interest rates?

The Fed expects bond markets to expect policy rates to be around 2%, or slightly higher, at the peak of this upcycle. That means the Fed and markets believe the central bank will stop inflation while never pushing real interest rates above zero.

On the surface, this is an odd idea. Think of it this way. If all goes as expected, short-term interest rates will be 1% higher in a year than they are now, and real interest rates are still very low. How will this constrain the economy in any meaningful way? It seems far-fetched to think that such a small change would significantly limit consumer or business spending.

The range of opinions on this conundrum is very broad.

Paul Ashworth of Capital Economics believes that “even a little bit of the Fed loosening the gas” would actually have a considerable impact on the real economy. Not only are marginal decisions about whether to take on debt affected, but higher borrowing costs divert resources away from other forms of spending. Given that neutral interest rates (the rates that would prevail if the economy were in a potentially functioning state, with full employment and persistent inflation) currently look very low, even small changes in interest rates could be significant even if real interest rates remain negative.

(To be clear, Ashworth doesn’t think a 200bps rate hike will bring inflation back to 2%, but he thinks it will help).

My colleague Martin Wolf disagrees. As a matter of mechanics, he doesn’t think the policy will cool the economy to a great extent. He said it all boils down to credibility:

The action itself is not important. Instead, what matters is confidence that the Fed is serious about its goals. Then, if it’s not doing enough, the Fed will do more — more.So, the signal Yes Policies and signals may suffice on their own. . . but this only works if the revealed intent is credible. The less credible its intentions are, the more the Fed needs to do to show it’s serious…

For 40 years, the Fed has been around [Paul] Volcker’s credibility. Maybe it has to show again that it means it. That would be a nightmare. That’s why it’s dangerous to let inflation burst. The more that needs to be done, the less credible the required action will be. That’s why Volcker became necessary in the 1970s.

Rissmiller still holds the third view. The final phase of the Fed tightening cycle is an inversion of the yield curve, which shakes confidence, which in turn leads to tighter credit conditions:

If you assume the future is more uncertain, then inverting the curve is tricky to deal with. It hurts confidence and hurts the profitability of the financial sector. . . you’ll have at least one situation where people worry about the curve being inverted and take less risk. . . and then if the tide recedes a little, someone [a big creditor] Something goes wrong, then credit spreads widen, and it all reinforces itself.

These views may overlap considerably and are not mutually exclusive. But the diversity of views on how monetary policy works under low interest rates and inflation is a troubling fact that investors should keep in mind when trying to predict what comes next.

a good book

Decentralization is not worth the trouble.