Taps Coogan – April 20th, 2023

We’ve repeatedly made case over the past year that the leading indicators of inflation have been pointing to falling inflation and, while it may not feel like it, we’ve actually witnessed the third fastest decline in inflation over the past nine months since at least the 1950s and the fastest drop outside a severe recession.

Nonetheless, the ~4% drop in headline CPI since last June has only succeeded in brining CPI down to about 5%. Meanwhile, the case for a further rapid drop in inflation is weakening, something Mohamed El-Erian, Allianz Chief Economic Advisor, recently warned about on CNBC:

On the latest inflation data and the market reaction:

“Core inflation was not weaker than expected at 5.6% and that’s the one to look at and… flying under the radar screen are survey expectations of inflation. You had the New York Fed last week showing that inflation expectations for this year have gone up a full half-a-percentage-point. You had the Wall Street Journal… surveying economists. That’s up 0.4%. So what you are getting is recognition that inflation is going to be sticky at around 4%-5%…”

“I’ve been saying this for a while. If you look at how inflation has migrated from a few goods, food and energy, up to the whole goods complex, now to the service complex, and we’re starting to see it in wages, … that’s what happens when the Fed is late. That’s what we’ve seen in past episodes. Inflation goes from things that are interest rate sensitive to things that are less interest rate sensitive…”

“If we go higher for longer you have a lot of levered models that no longer make sense. We’ve seen what’s been happening with commercial real-estate and we’re not even through that process yet. So, there’s a lot of business models that will not make sense in the world of higher rates for longer… How do you de-lever these over-levered sectors? …When people come to refinance certain activities, they won’t make sense at these higher rates?”

All things being equal, we can’t help but agree with Mr. El-Erian. We are probably through the ‘easy’ part of reducing inflation.

Of course, all things are not equal and the point that large swaths of the economy can’t support this interest rate environment is precisely the argument that inflation can drop further as economic activity slows. That’s the ‘inflation drops further because we have a recession’ argument, aka the ‘hard’ part. 

We’ve written frequently about the probability of recession and operate on the assumption that we’re pointed towards one. However, we frequently point out that it need not be a severe recession. It’s worth remembering that, after all the Covid stimulus, Congress passed roughly $2 trillion of stimulus spending via the infrastructure bill, the ironically named Inflation Reduction Act, and the CHIPS Act. That money is starting to hit the economy now and represents more than twice the fiscal response to the Global Financial Crisis. 

So, while one should assume that we’re headed for a recession, it’s unlikely to be that useful of an insight. Instead, a longer quasi-recessionary period of declining-but-still-too-high inflation and listless financial markets is perhaps a more useful working model.