Inflation Could Be Harder to Tame Than the Fed Anticipates

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Market participants returned from their summer holidays apparently undaunted by the consistent and persistent message from central bank officials that short-term policy interest rates must be lifted significantly further to bring inflation to heel.

U.S. stocks broke their three-week losing streak, with the

S&P 500
index adding 3.65%, even as the probability of a 75-basis-point hike in the federal-funds target at the Sept. 20-21 Federal Reserve policy meeting climbed to 90% by Friday from a bit more than even money a week earlier, according to the CME FedWatch site. That followed a similar-size boost by the European Central Bank this past week and expectations of a further increase of 50 or 75 basis points in the Bank of England’s policy rate at its Sept. 22 meeting, which was postponed a week owing to the death of Queen Elizabeth II. (A basis point is 1/100th of a percentage point.)

Markets appear relatively sanguine, despite the possibility of an additional 50-basis-point increase in the fed-funds rate at the Fed’s Nov. 1-2 meeting and a 25-basis-point rise at its Dec. 13-14 confab, according to CME futures prices. The latter move would bring the key rate to a “terminal” range of 3.75% to 4%, from the current 2.25% to 2.50%.

But even a 3.75% or 4% policy rate might not bring inflation within shouting distance of the Fed’s long-term target of 2%. Inflation is running far above the 4% top interest rate anticipated by fed-funds futures. That means money costs less than nothing, after inflation. To curb inflation, money has to be dear, in real terms.

For clues as to whether the inflationary tide is receding, stock and bond markets will closely watch the August consumer price index, slated for release this coming week. Owing mainly to a big drop in retail gasoline prices, economists forecast a 0.1% decline in the overall CPI. That would lower its 12-month increase to 8.1%, from 8.5% in July and the four-decade high of 9.1% in June. Excluding food and energy prices, the “core” CPI is estimated to have risen 0.3% last month, raising its year-over-year increase to 6.1% from 5.9% a month earlier.

In addition, wages aren’t keeping pace with rising prices. The Atlanta Fed Wage Growth Tracker shows pay increasing at a 6.7% year-over-year clip in August, the same pace as in July. That’s far above the Fed’s inflation target, but short of the rise in the CPI.

For Douglas Peta, chief U.S. investment strategist at BCA Research, these numbers suggest that a fed-funds terminal rate above 4% will be necessary to corral inflation. The pace of price rises will slow to 4% of its own accord, regardless of what the Fed does, he predicts in a telephone interview. Even apart from energy and food, other prices have come off the boil, notably those of used cars, a huge driver of inflation during the worst of the pandemic.

Trimming inflation to 2% from 4% will be more difficult, Peta adds. Once markets realize that this will require a higher terminal fed-funds rate than the 4% they anticipate, stocks and bonds are apt to correct. That’s likely to be a 2023 event, while the markets and the Fed play a game of chicken as tighter money takes a toll on the economy.

To be sure, the fed-funds rate doesn’t fully capture the degree of policy tightness. Lisa Beilfuss’ interview with a former Fed trader explains the impact of the shrinkage of the Fed’s balance sheet. Jefferies’ chief financial economist, Aneta Markowska, also estimates that the rise in the dollar effectively raises the fed-funds rate by 100 basis points.

But that still leaves that rate below the pace of inflation. While Fed speakers insist that the central bank won’t relent until inflation is vanquished, their own forecasts see that being achieved without a significant rise in unemployment. Which is to say, it’s different this time.

Write to Randall W. Forsyth at [email protected]