Serenity Now

Jun 30, 2022

As I hear Larry Summers or Bill Dudley who sound befuddled about the Fed's failure to recognize the risks to higher inflation, the image of Frank Costanza yelling "Serenity Now" flashes in my mind. Speaking of serenity, central bankers gathered in the gorgeous town of Sintra to attend the ECB Forum on Central Banking - or more like Inflation Anonymous group therapy workshop - a little prayer for central bankers in thinking about inflation -

Grant to us the serenity of mind to accept that which cannot be changed; courage to change that which can be changed, and wisdom to know the one from the other

This is a bit of a dense note but in thinking about inflation, a deep dive over sources of inflation is warranted to understand what to what extent and over what period can the central banks influence them and the potential costs associated with addressing them -

Goods Inflation

The unique nature of the Covid shock which reduced mobility and the large fiscal impulse combined with forced savings led to a historical surge in goods consumption - partly because the at-home lifestyle including moving to the suburbs and work-from-home needed additional goods and partly because consumers couldn't spend it on services. The good news on this front is three-fold - decline in fiscal transfers and erosion of savings due to high inflation, consumption rotating back to services away from goods as economies reopen and pull forward of large durable goods during Covid will see payback. This should return goods consumption back to trend and in y-o-y terms sharp declines are likely ahead of us. One caveat is that there is still residual pent up auto demand but higher financing rates and negative real incomes will dampen that demand somewhat too. Aside from that, the decline in goods demand is evident across earnings calls from major retailers.

The supply-chain bottlenecks with goods are well advertised and mostly well understood at this point so I won't beat a dead horse to death. But the supply side was further exacerbated by the sheer size of the demand shock and even in absence of Covid lockdowns, I would argue the supply-side wouldn't have been able to keep up with increase in demand. As the supply-chain problems heal, retailers are finding themselves with another issue - miscalculation in ordering. Part of this is the bull-whip effect across the supply chain where each link of the chain over-orders to account for supply issues amplifying orders relative to underlying demand and resulting in an inventory glut down the road. The other element which isn't talked about as much is that demand forecasting is basically about extrapolating trend. And it's hardly a surprise that given the sharp jump in trend in goods demand post-Covid, even with conservative forecasting, it might prove to be still too optimistic as demand for goods reverts to pre-Covid trend. It is quite likely that as demand declines, aggressive discounting leads to goods deflation in the quarters to come. Autos remain the one large part of the goods inflation basket that are still under supplied and that supply demand imbalance needs to normalize before the goods deflation becomes a tailwind for lower inflation.

From the Feds perspective, raising financing costs weighs on housing and auto demand and weaker housing in turn slows demand for durable goods. This coupled with a organic slowdown due to rotation into services and potentially an inventory glut problem implies that the Fed is leaning into a downtrend and the goods sector would be a significant contributor in enabling the Fed being able to get inflation towards its target. The caveat is that the goods deflation may prove to be transitory and underlying inflation ex goods might still prove to be too high for Fed's comfort. But slowdown in inflation from goods will be welcomed by the Fed and sufficient to slow the tightening in the least and potentially provide enough cover to pause the tightening cycle in the event of a sharper decline in economic activity or increase in unemployment.

Commodities Inflation

There is a structural aspect of this which is more of a multi-year phenomenon and dependent on two variables - geopolitics and green transition. Extrapolating the current geopolitical state of the world and focus on ESG discouraging investments in hydrocarbon exploration would suggest a tailwind for commodity inflation in the coming decade. However, the dominant factor in the market today is the Ukraine/Russia war and the path or end game is far from clear. I am definitely not an expert on the matter and my opinion would simply add to the noise. However, the tails are fat on either side particularly for Europe as we head into the winter.

This is an inflation dynamic that the central banks have little control over and given relatively inelastic demand for gasoline and food, the demand destruction needed to get prices lower is probably too high. In the past, when other components of inflation were less threatening, the Fed had the luxury of viewing oil price increases as a shock to consumption. However, commodity price inflation in an economy with a tight labor market and with broad inflationary pressures poses a risk to un-anchoring inflation expectations and can't be dismissed and definitely can't be viewed through a growth shock lens. The appropriate calibration of policy in response to commodity inflation is a function of labor market tightness, real wages and bargaining power of labor. In the current environment this is extremely tricky given tight labor markets but negative real wages - particularly in Europe. Using a heavy-handed approach carries high risk of a policy mistake particularly if either of the fat tails materialize.

Covid Impacted Services

The rotation to goods from services in a Covid impacted economy resulted in sharp drop in demand and prices for services like travel and hotels. These sectors had to aggressively cut capacity to shore up their balance sheet. The reopening led to strong demand in these sectors and without restoration of capacity back to pre-Covid levels, it caused a sharp reversal in prices. A chunk of this inflation is a price level adjustment to pre-Covid levels but more recently a significant portion is a result of supply demand imbalance and impact of increases in oil and labor costs. The rotation of spending back to services should sustain demand somewhat and initially be relatively resilient to Fed tightening. But as the Fed tightening works its way through the system, slowing the economy and labor markets, the demand for consumer and business travel should soften. Businesses in particular have adapted to a Covid world with virtual meetings / conferences and cutting business travel is a low hanging fruit to cut costs as earnings face pressure from slower growth. These sectors returning to pre-Covid inflation trend is well on the cards in the coming quarters.

Rent

In my opinion, this is the component of inflation that poses the most significant challenge for the Fed. For one, it has inertia and is currently showing strong momentum. Secondly, it lags house prices by around 18 months and given sharp home price appreciation since Covid, rental inflation is unlikely to show respite anytime soon. Furthermore, even with rising mortgage rates house prices are still holding up due to constrained supply. Higher mortgage rates perversely worsen supply due to consumers not wanting to give up their existing lower mortgage rates by selling their homes and weaker housing demand that weighs on new home construction. Lastly, it is the part of the CPI basket that is among the most sensitive to the labor market and it will likely stay firm as long as labor market remains tight. As policy tightening starts to raise unemployment rate, the rent inflation will slow but the process will take time.

Wages

Wage inflation is one area which falls squarely in the domain of central bank. The labor markets around the globe are tight and alongside a backdrop of high inflation, the risks of rapid wage price inflation are real. While this isn't the 1970s with high unionization and labor with strong bargaining power, the internet has made it much easier to switch jobs and drastically increased transparency on market wages. Since Covid, the quit rates have risen to record levels.

But there is a labor supply problem that can't be ignored. One of the major structural factors is drop in immigration. Foreign born workers make up significant part of the labor force in sectors seeing significant labor tightness and wage inflation - healthcare, leisure and hospitality, business services. Apart from that some of the labor supply issues is due to rise in early retirement which is in my view is a function of elevated Covid fatality risks for the older population and surge in housing and equity wealth post-Covid. The other factor at play is to do with childcare problems which is partly related to school closures during Covid and partly to lack of availability of childcare workers due to reduced immigration and higher wages in other sectors competing for the same labor pool. Some of the labor supply has returned to normal as evidenced by rise in labor force participation, but other factors like immigration are unlikely to see major relief anytime soon.

But at the end of the day, when it comes to wages the buck stops with the central banks. They have to cool labor demand and even reverse it (given unemployment rate is probably well through short-run NAIRU) to slow wage inflation. This needs tighter financial conditions which worsens outlook for earnings growth forcing corporates to play defense and reduce hiring and layoff workers to cut costs. Fed policy can certainly achieve that and it is clear from their communication that labor market will be their guiding north star in setting policy. The appropriate calibration of policy using wages is quite difficult in reality. Firstly, labor markets are a lagging economic indicator and have a lot of inertia. Secondly, if the Philips curve is flat due to labor supply issues, the sacrifice ratio is going to be a lot higher and Fed would need to engineer a recession, possibly a large one, to restore balance.

Inflation Expectations

The Achilles heel of any inflation targeting central bank is un-anchored inflation expectations but measurement of inflation expectations in real-time is fraught with complexities. Short-term inflation expectations are highly correlated to the energy and food prices which are volatile and typically not considered as good predictors of underlying inflation trends and hence excluded in the core measures. Long-term inflation expectations are technically the right ones to focus on but are slow moving and due to their inertia might be hard to anchor once they start moving. Market-based inflation expectations - particularly forwards like 5y5y - theoretically are good barometers since they take into account forward impact of central bank policy on growth. But they have not been in existence long enough - particularly during periods of high inflation - to place high confidence in them.

As was evident from Powell's decision to go 75bp partly in response to move higher University of Michigan long term inflation expectations, central banks are sensitive to this. But a subsequent revision down to the data highlights the challenges with over-reacting to them. Of course, the argument can be made that the revision lower was an outcome of the forceful Fed action. But we will never really know the counterfactual. In my opinion, inflation expectation measures are critical in setting direction of policy from a risk management perspective but not necessarily for calibrating size of near term policy moves.

In summary -

Goods inflation is likely to provide a strong tailwind for lower inflation particularly later in the year as auto inventory situation is resolved and the lagged effects of policy tightening feed through to demand. The risks of severe deflation in goods sector in Q4 2022/1H 2023 is non-trivial in my view.
Services benefiting from Covid rebound should slow but rent inflation is going to keep trimmed inflation measures firm at least for the next few quarters. The key to sustainably slowing rent inflation will have to come from a significant slowdown in labor market.
The sacrifice ratio for curbing commodity inflation is very high and if central banks react aggressively to headline inflation or short term inflation expectations, risks of a major policy mistake and earlier and deeper recession rise substantially. The risk is most acute in Europe.
Wage inflation is what the central banks own completely and the labor market will be the primary driver of policy. Since labor market typically lags and Philips curve could be flatter given labor supply constraints, the risks of overshoot by central banks is very high and in my view very much the base case.
Inflation expectations are a dominant variable in overall stance and direction of travel for monetary policy. They will prove to be extremely critical if and when a reversal is policy is needed. Without a green-light from inflation expectations, reversing policy decisively will be extremely difficult for central banks even in face of a recession.