This was a very busy week of macro data and events, including updates to the CPI, retail sales, industrial production, initial jobless claims, and the FOMC policy meeting.
We’ll start by looking at the inflation data and then talk about the FOMC meeting and how monetary policy is dangerously opposed to the current trajectory of the economy.
Starting with the CPI report, we can clearly see how the momentum of inflation shifted around the late summer of 2022.
This chart shows the 3-month annualized change in various CPI measures. Total CPI, graphed in orange, has cooled from 10% to 2.2% on a 3-month annualized basis. Total CPI Less Shelter (green) has declined from the 12% range to 0.1%.
Even Services Less Rent has normalized, falling from 11% to -0.6%. Core inflation is still uncomfortably elevated at 5.0%, but it’s abundantly clear that the lagging rent or shelter component is keeping the Core measure high while almost all other areas of inflation have normalized.
This lagged nature of inflation is part of the process and a big reason why core inflation won’t bottom until a year or so after the recession is over. The parts of inflation that have the ability to move in real-time have shown a marked change since the first half of 2022.
As the rent/shelter component slowly trickles down, core inflation will drift lower, revealing monetary policy to be increasingly tight.
The biggest changes to the Federal Reserve stance after the FOMC meeting this week were the increase in the Fed Funds projection from 5.1% to 5.6% and the widening of the longer-run range from a band of 2.4%-2.6% to a band of 2.4%-2.8%.
The Real Fed Funds Rate, measured by the Fed Funds Rate less 6-month Core CPI, is roughly 0%, rising from -6% in early 2022.
The downward trend in the real Fed Funds rate is due to the secular forces of lower population growth and higher debt levels.
The economy was only able to withstand a real interest rate of 0.2% in 2018 before the Fed had to start cutting interest rates.
Today, the Real Fed Funds Rate is back to the same level but will continue to increase from here even if the Fed doesn’t raise rates anymore due to the decline in Core CPI from the lagged shelter data.
The economy is unlikely to withstand a higher level of real interest rates compared to five years ago when the debt and demographic profile, both domestically and globally, are materially worse.
Nevertheless, the Real Rate will rise and increase pressure on the economy at a time when recessionary conditions are proliferating through a wider basket of data.
Real Retail Sales growth has been persistently negative, a situation that’s extremely uncommon outside of recessionary periods.
Since both headline inflation and coincident growth are both cooling, nominal growth is hitting new cycle lows.
This shows the combination of our six-factor NBER Coincident Index plus CPI inflation. Nominal growth has decelerated from 12% at the start of 2022 to 4.6% as of May, back to the long-run average.
It should be noted that the 2008 recession started with nominal growth of 5.6%, so it’s entirely unjustified to use nominal growth as a recession indicator.
More importantly, the Fed has raised the Fed Funds rate above the trending level of nominal growth, a situation that unsurprisingly occurred in past pre-recession or early recessionary periods.
Monetary policy is extremely tight relative to the trending level of nominal growth.
As inflation and growth (nominal) both continue to decline, monetary policy will get increasingly tight, even without further rate increases.
The problem is that even tighter monetary policy will come as the labor market is showing increasing signs of stress.
We’ve covered the Leading and Coincident Employment Indicators in past reports, so this week, we’ll just look at the updated initial and continued claims data which brought more evidence of worsening labor market conditions.
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This is a sample of the EPB Market Update, Week 24.
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