Posted by - News Worthy -
on - December 18, 2022 -
Filed in - Impacts -
inflation economy policy oil Worse -
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The Path to Q1 Deflation
The odds that we get at least one month of negative inflation data in Q1 is increasing. Will deflation become a concern in Q1? That is possible (and maybe even probable) if we continue on the course of action that we are currently taking. I do not believe that we will be worried about inflation in a meaningful way by the end of Q1. In fact, as you can tell from Inflation Risk Factors and 2 + 2 = 5, I think that we have already set ourselves on a course that we will regret.
Today we will outline how and why Q1 deflation is a bigger risk than having high inflation in Q1. I use the term “risk” because the deflation will be linked to a recession that starts sooner and will be worse than consensus (Friday’s data makes me wonder if it hasn’t already started).
Inflation
Let’s start with a closer look at where we are with inflation today.
Inflation Elimination/Simplification
This chart includes three common measures of inflation – CPI, CPI Core, and PCE Core. The point of this chart is to justify only looking at Core CPI. They all move more or less in line, with overall CPI being a little more volatile and PCE being a month behind in terms of data. So, when we use CPI in charts in later sections, we will use Core CPI because we don’t give up much information in terms of the narrative that we are creating and the charts will be much simpler to understand.
Core CPI – Chart Looking Better
Two things that stand out on this chart:
The Lag Effect in Action
I’ve used the two-year yield here as it is a good representation of what the market is pricing in for monetary policy at the front-end (the 10-year “marches to the beat of many drums” and the front-end only responds to the actual hikes, not the anticipation of hikes, which is a monetary policy tool in and of itself).
This chart, while volatile, seems to offer some reasonably clear evidence that:
The lag effect is real and even with that lag, inflation is behaving better. What happens when more hikes (that have already been announced) kick in? Deflation seems to come to mind, but we have potentially only just begun to go down that path.
Let’s Not Forget the Balance Sheet
Quantitative Easing:
So, while the market is fixated on terminal rate projections (more on that in the next section), maybe we shouldn’t ignore the impact of QT which no one has talked about changing (and they shouldn’t). I’m convinced that someone will win a Nobel Prize for highlighting how dangerous QE is as a policy tool.
To summarize this first section:
Part of me would like to type QED now and say that we’ve proved our point and enjoy the rest of the weekend, but there is a lot more to write about to convince you why deflation is the path that we are on.
Don’t “They” Know Better?
If the policy makers had a great record of success, then I wouldn’t be worried that we are making a huge mistake and their efforts to fight inflation risk are creating a deeper recession than is necessary. But they did miss inflation and there is no reason to believe that they are any more likely to get it correct this time. In fact, you could argue that they are more likely to get it wrong, because they are dealing with the damage to their reputations from missing inflation and may have a problem acting objectively.
The DOTS – 1 Year Apart
This week the Fed spent time convincing the market that the terminal rate needs to be higher. This time last year not a single person had rates above 3% (at any time) out to 2024! By this time last year, the “transitory” story had started to shift, but we were still doing QE and talking about possible hikes, though the consensus was for less than 1% by the end of 2022! This wasn’t just a little wrong, it was very wrong! Sure, Russia’s invasion was unknown, but all throughout the year they increased the dots and terminal rate. I look at this dot plot and it gives me the energy to continue to the next section. At least I can be on the record if their hiking goes “pear shaped” and hurts the economy and the country far worse than was likely necessary!
Oil and Sauron
There are several “next steps” I could take on the path to deflation, but let’s start with oil. I guess Sauron could refer to Putin, but I was thinking more in terms of “one ring to rule them all.” There is no commodity as important as oil because it permeates the economy. It impacts the cost of producing goods, the cost of shipping goods, and how much money consumers have to spend on goods.
If Russia has to capitulate and come to some sort of a truce oil will drop even further, but that is not part of the current analysis.
Oil – Not Great, but Not Horrible
Despite OPEC+ curtailing production, the ongoing war in Ukraine, the alleged re-opening of China, and the U.S. making some purchases to refill the Strategic Petroleum Reserve, oil prices are coming down. From a CPI perspective (not Core because it excludes energy), it will be a good thing.
The two biggest “benefits” are that production and transportation costs will drop which will help to reduce inflation. But as discussed in Incongruous we should be careful what we wish for.
I use the 6-month forward WTI contract to smooth things out, but typically as oil goes up, stocks do well (and vice versa). That was the case from 2016 until just recently.
The same pattern holds true for the 2003 to 2011 period (with a couple of short exceptions).
Even from 1999 until 2002 the pattern held up pretty well.
In any case, I’m not sure we should cheer low oil prices. Maybe what is counteracting all of the potential reasons for oil to be higher is that the economy is slowing much faster than is currently showing up in the official data.
I argued (vehemently) back in 2015 that higher energy prices were great for jobs and the economy overall and I still believe that.
At the time, energy was a big part of the high yield market which struggled during that timeframe (there was even an “ex-energy” ETF launched in early 2016). I think back to how that one sector so heavily affected some markets and the economy and cannot help but think of parallels to today.
The Disruptive Economy
We highlighted this so much last weekend in Inflation Drivers that I won’t rehash the argument here. What I will add is that when I look at some jobs data, "management” makes up 6.3% of the workforce but 13.4% of the income and it seems like those jobs are under pressure.
Computer and math jobs are only 3.3% of the workforce, but 5.7% of the costs. This area is still strong, but I am seeing the reshuffling of jobs as some big companies are cutting back here.
These two areas, which rank 1 and 3 in terms of wages (legal is number 2) could face pressure. That will make even small amounts of jobs lost more impactful.
Just like “energy” was the main focal point of economic (and market) problems in 2015, “disruption” seems to be front and center right now. However, while this sector isn’t a big part of the debt markets, it is a large part of the equity markets (and alternatives) and why there could be a lot more pressure if the slowdown persists (rates aren’t the main driver here, but they are not helping).
Take This Job Data and Shove It
In 2 + 2 = 5 we highlight the issues around job data, particularly the Philly Fed’s report that Q2 jobs were overstated by more than 1,000,000 in the NFP reports!
The year started with 1.3 million more workers on the Establishment Survey than on the Household Survey. They differed by 950k in Q2 (maybe the Philly Fed report has some substance).
There are a lot of issues with both sets of data, but it seems a bit “optimistic” to only focus on one measure, especially after the work the Philly Fed just did.
To put this in a different perspective, in March the unemployment rate was 3.6% (it is now 3.7%). That is based on the Household Survey. The Establishment Survey showed that 2 million more jobs were created since then, so if those jobs had shown up in the Household Survey, the unemployment rate would be about 2.2%. Just think about that. If the jobs in the Establishment Survey are correct, even from just the start of the year, we’d have sub 3% unemployment. Does this feel like an economy running that hot?
There are so many questions on the quality of the job data (and ADP is somewhere in between since they started republishing this year with their amended methodology) that it seems difficult to base our view on the job market on these numbers.
ISM Jobs Story Seems More Realistic
2021 was HOT! Lately, not so much! Not awful, though several months below 50 this year (even for services) doesn’t hint at a job market that is out of control, especially for the high paying jobs that really drive inflation!
I’m trying to get better at pulling data directly from indeed.com. I’m told, by some good people, that it is dropping faster than JOLTS, but I cannot yet verify that myself (at least not in an intelligible way).
This Policy Mistake Will Be Worse Than the Last
It is bad to miss inflation (especially when there were so many telltale signs that it was real and not transitory) but it will be worse to trigger a recession that is avoidable.
Who cares what the stock market does over a day or a week? Who cares if financial conditions improve a bit when so many other factors (including QT) are combining in a “perfect storm” to “normalize” inflation!
I am extremely worried that we have already done too much, and that we are pushing our economy into unnecessary danger zones when we should be focused on transforming our energy industry, redeveloping supply chains, improving trading relations, and ensuring that we are “safe” from pandemics (or at least more in control of the necessary materials).
The fight against inflation is now misplaced, and I’d rather see us living with 3% inflation and striving to accomplish a lot, rather than creating unnecessary job losses and opportunities for our competitors.
The path to deflation is becoming less avoidable and beating inflation (so badly) is not the victory that we should be striving for.
This week’s “risk-off” trading with low yields and lower equities may be a harbinger of things to come based on our apparent policy priorities and data “analysis.”