The Fed Has An Alarming Low-Inflation Problem

With all the talk of central bank hawkishness in the last week, one might assume there was some inflation to point to. It is quite the opposite. It is one thing to talk about inflation being below the Fed’s target of 2%, it is an entirely different issue to see it flirting with deflation! Shorter-term trends of core-inflation are very near to 0%, levels we haven’t seen since the great recession and the advent of quantitative easing.

In its most common form, inflation is quoted by measuring its percentage change compared its level 12 months ago, the so-called year-over-year (YoY%) metric. But, shorter-term periods can be measured to get a sense of more recent trends as well as if there is acceleration or deceleration in the metric. The shorter the period measured, the more volatility the metric has, and so year-over-year (YoY%) has become the standard. It also has the added benefit of eliminating any seasonal effects.

In the charts below, we show the two top-tier measures of consumer price inflation, the Fed-preferred core PCE deflator, and the core CPI; with its common year-over year (YoY%) format, 6 months back annualized, and 3 months back annualized. Comparing the three gives a sense of acceleration of deceleration. If the 3mo. is less than the 6mo. is less than the 12mo., there is deceleration and vice-versa, there is acceleration.

 

But, beyond these charts, evidence of low inflation abounds. The headline versions of these numbers (including oil and food) are negative over the last three months, the ‘prices paid’ component of the manufacturing ISM number fell by a large amount in a release on Monday (7/3), the ‘prices paid’ component of the Service-sector ISM is now contracting, inflation expectations in all indicators have been falling since February, and the OECD published a report yesterday (7/4) that the inflation rate has fallen for four straight months in G-20 economies.

Despite the excitement last week at the prospect of global central banks moving away from easy money policies, there is no fundamental basis for this. We expect that the Fed will soon need to move to a neutral from tightening bias.

Trader Warns: Fed Rate Hike Will Be The "Death Knell" For Reflation Trades

Thanks to commodities, Bloomberg"s Mark Cudmore warns that the Fed meeting is more likely to be the death knell for reflation trades rather than mark their moment of victory.

This week is set to provide confirmation that we’re in the midst of a true tightening cycle in the U.S., with rate hikes in consecutive quarters for the first time since 2006.

10-year Treasury yields hover just below the two-year high, but I don’t see them breaking higher in an environment where commodity prices are plunging.

Oil was just the latest victim last week, with prices falling the most in four months. The broader Bloomberg Commodity Index topped out a month ago, with everything from metals to agricultural goods turning sharply lower since then.

This undermines the reflation trade in three ways.

1. Most directly, it’s hard for inflation to keep accelerating when input prices are slumping.


2. It also suggests that real demand is not growing as quickly as hoped, which provides caution on economic optimism.


3. Finally, while cheaper commodity prices are a long-term positive for economic growth, the more immediate wealth/portfolio effect is negative.

Price data from the U.S. this month has validated the suspicion that inflation is not rising as fast as forecast, with the PCE deflator coming in below expectations.

This isn’t an environment that supports much higher long- term yields. Add in the context that speculative short positions in Treasuries remain near record levels and it appears to be a market ripe for a squeeze.

Furthermore, as Bloomberg"s Richard Breslow concludes:

The abrupt about-face by the Fed has dealt a severe blow to the efficacy of forward guidance.

Markets will understandably assume that central banks are now using commentary as a tactical device to control the moment rather than a way of describing a strategic plan based on long-term forecasts.

It means we are in for a lot more false steps, conspiracy theories and greater volatility