Whether we hold Treasurys via the world’s largest money market fund or directly really does not matter. Inflation does not come from debt alone, but from debt relative to a credible plan, and expect that debt will be repaid. Expected inflation is anchored by the belief that if inflation gets out of control, our government will promptly put its fiscal as well as monetary house in order. Moreover, since our government has tragically borrowed short-term, inflation comes when people believe that other people will lose this faith.
After German troops were defeated in a pivotal battle at El Alamein in 1942, he commented that it was «not the end, not even the beginning of the end but, possibly, the end of the beginning.» That’s probably a fair assessment of the state of the west’s war against inflation after a week that looked like a turning point.
This comment from Bespoke Investment LLC sums up the mood by the end of the week
«After a strong jobs report last Friday reignited fears of an overheating economy, markets were edgy heading into a busy week for inflation data. It doesn’t happen that often, but the bulls hit the inflation superfecta. It started with Monday’s release of the July Survey of Consumer Expectations which showed a continued decline in inflation expectations. On Wednesday, the big bad CPI report for July was released and that came in lower than expected for a change.
After months where it seemed as though every inflation report was coming in hot, this week’s data on prices was cold, cold, cold, and cold. » In particular, the headline US CPI index for July was unchanged from June, meaning that month-on-month inflation had actually dropped to zero. The response on stock markets also suggested that the end of the beginning of the bear market that started in the US at the outset of this year had finally been reached. Some technical analysts suggest the S&P 500 still has to move above its 200-day moving average, which is close, while many are now prepared to declare that this is a full-fledged new bull market.
I think it’s worth returning to the Inflation Indicators.
The aim was to try to tell whether the low-inflation paradigm that had persisted since the Global Financial Crisis of 2007–09 had at last been broken. The idea was to decide on a list of indicators of different aspects of inflation and give them a Z-score, which measured how many standard deviations they were above or below their mean for the previous 10 years. For each indicator, the more standard deviations above normal, the darker blue they would appear on our heat map.
The amount of blue has increased slightly, but that’s large because the economic forecasters polled by Bloomberg are more nervous about inflation. They show significantly less pressure than they did. Shelter inflation is now four standard deviations above its norm for the last decade. As it accounts for a third of the index and tends to come through with a lag, this bodes ill for headline inflation descending quickly to 2%.
Meanwhile, the cost of recreational services is also now rising at two standard deviations above the mean as the economy reopens. The turn of the sentiment indicators, and the decline of raw materials prices, are both positive signals. Barring a fresh geopolitical shock to send commodity prices higher again, the remaining concerns are house prices and rents and wage inflation. So this exercise justifies an outbreak of market happiness.
But the extent of the rally looks overdone, because of the critical issue of how long it will take to bring inflation down. That would have been regarded as a nightmare scenario when this year began, and with wage negotiations concentrated in the beginning months of the year the risks of a «wage-price spiral» would intensify. Now to see if victory can be obtained more rapidly than it was after El Alamein.
Soft Landing?
Returning to optimism, last week’s data does suggest that a «soft landing,» in which inflation comes down without a major recession, does at least now seem possible. The very strong employment numbers make it look as though recession talk has been premature. It also continues to be the case that the shifts in the economy are happening in a more egalitarian direction. As I pointed out last week, wages are growing faster for the lower-paid.
Data from the University of Michigan on Friday further showed that it was they who were gaining most in optimism about inflation. « Notably, the index for consumers’ expectation for near-term gas prices decreased substantially, to 10.3, from 21.0 in July and 41.2 in June, suggesting that falling gasoline prices may play an important role in the improvement of consumer sentiment. Buying conditions for durables, including motor vehicles, deteriorated in August after the improvement in July, as »high-income consumers registered large declines in both their current personal finances as well as buying conditions for durables. «After a post-crisis recovery in which the lower-paid were left behind, an economic slowdown that saw them catch up to some extent might well feel that much more like a »soft landing.
«If there’s a worrying indicator for the economy, it comes from inventories.
As with stocks, the rally embodies a lot of macroeconomic optimism. Simply put, this economy does not hire half a million new workers into a recession. Second, the CPI report on Weds offered the first tangible piece of evidence that the inflation peak may be happening. We have been consistently emphasizing weakness in commodities as a leading indicator of this, but the CPI print offers a hard data point to support this.
credit conditions have been improving fast on the back of a major market rebound from July. If the perilous descent from Peak Inflation continues successfully, the credit market will continue to validate the recovery in other risk assets. But it wouldn’t take much difficulty for the credit market to shake some of today’s positive assumptions. These data are encouraging, but it’s too soon to call the all-clear.
In conclusion, while we may see some short-term volatility due to market fluctuations and trade wars, there are reasons to believe that the future is bright.
