The New World of Inflation

The last five economic recessions were all preceded by a spike in crude oil prices. Does that mean we should worry about yesterday’s historic jump in the price of oil? In a word, no.

Recent attacks on Saudi Arabia have focused attention on the impact of higher energy prices, which generally work against all sectors of the economy other than energy. But an abundance of supply suggests that prices are unlikely to run away to the upside.

Light Crude Oil

In addition, since a large portion of the junk bond market is comprised of the debt of energy companies, the rise in oil prices is actually helping to reduce risk in the junk bond market. Also, with the U.S. being a net exporter today, as opposed to a net importer in the past, higher oil prices represent a changing dynamic.

I don’t want to spend a lot of time on this, as I think it’s a non-issue for now, but since it’s front page news I thought I’d address it briefly.

Moving on, the Fed’s two-day FOMC meeting began today, with a rate decision due out tomorrow. Expectations in the fed funds futures market have changed considerably over the past few weeks, with market participants now expecting only a 50% chance of a rate cut.

If you ask me, I think we’ll see another rate cut, simply based on Chairman Powell’s recent remarks. He believes the market is expecting another cut, and he’s already been chastised a few times for disappointing Mr. Market.

In addition, Mr. Powell is being pressured to lower rates by the ECB, which launched a major stimulus package last week in addition to lowering their benchmark rate deeper into negative territory. This has placed upward pressure on the dollar, which remains in a longer-term uptrend.

Just so you’re aware, there are two factors that are helping to reduce the market’s pricing in of further rate cuts. The first is a rebound in the yield on the 10-year Treasury.

Central banks get worried when long-term interest rates drop because they fear it implies a shift toward lower inflation expectations. Since deflation is a central bank’s worst enemy, the recent uptick in yields seen below is surely a relief.

Yield on the 10-year Treasury

The second factor reducing rate cut expectations has been a firming of actual inflation. Recent CPI data for August showed an uptick in core inflation to 2.4%, while headline inflation remained steady at 1.8%.

Consumer Price Index (Headline and Core)

We have not yet seen the August data for Personal Consumption Expenditures (PCE) – the Fed’s preferred measure of inflation, but the two indexes are highly correlated so it’s assumed it will come in on the stronger side as well.

With core CPI running above the Fed’s 2% target, a logical question to ask is whether this will deter additional rate cuts moving forward. That’s a difficult question to answer, as inflation is only one part of the Fed’s dual mandate, but I think it’s important to remind you that how the Fed thinks about inflation is evolving.

As we discussed previously, the Fed is considering modifying their inflation targeting protocol to account for inflation over the entire business cycle, as opposed to just a point in time. What this means is that we’re likely to end up in a situation where the Fed is content to allow inflation to run hot (above 2%) to make up for periods when inflation was low, so that inflation over an entire economic cycle averages out to their target of 2%.

To be clear, this is not part of their current policy framework, but it’s pretty clear that things are moving in that direction. When you consider that inflation has been below their target for the vast majority of this economic expansion, it’s not hard to envision a situation where they continue to cut rates – or hold them steady – as inflation rises above 2%.

Let’s also not forget that above-target inflation is very easy to fix with tighter monetary policy, while below-target inflation can be nearly impossible to remedy, as we’ve seen here in the U.S., in the EU, and particularly in Japan.

Anyway, regardless of whether the Fed cuts rates tomorrow or not, it’s not likely to have a major impact on markets as a rate cut is not strongly priced in.

Before we switch gears again, I thought I’d show you this chart of historical inflation across the G-7 countries. It’s rather interesting that both the internet, and mass globalization came to the forefront during the ‘90’s, right as we entered the so-called “New World” of inflation.

G-7 Nations Historical Inflation

Based on this chart, it’s difficult to predict global inflation making its way above the 2% mark anytime soon (particularly with rates already below zero in most of the world and exotic policy in play), but only time will tell.

Now let’s take a quick look at price action. Below we can see the S&P 500 getting awfully close to its recent all-time high, set in July.

S&P 500

The other major averages are looking quite similar. In the top panel below we can see the Industrials trading very close to their all-time high. Below that, the Transports aren’t showing quite the same level of strength, but they’ve come a long way since almost transitioning into a bearish trend in August.

Dow Jones Industrials and Transports

And it’s the same story with the Nasdaq …

Nasdaq Composite

Overall, I think there’s a good chance we’ll see the market notch new highs, but at the same time I doubt the market will run very far until some of the uncertainty around trade is reduced … and who knows when that will happen.

In the meantime, the economy remains okay for now, propped up by the services sector. As long as services can remain buoyant long enough for manufacturing to regain some footing, there’s a chance we’ll stave off recession. Not indefinitely, mind you, but at least for a little while longer.

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