US headline and core inflation readings sent shockwaves throughout markets over the past week. In August, the Consumer Price Index for All Urban Consumers increased 0.1 percent, seasonally adjusted, and has risen 8.3% over the last 12 months, not seasonally adjusted. The index for all items minus food and energy increased 0.6% in August (SA); up 6.3 percent over the year (NSA). The moment everyone expects that high prints will be confirmed, other CPI components spoil the party. For instance, prices for food at home increased 13.5%, the largest 12-month percentage increase since the period ending in March 1979. Prices for food away from home increased 8.0% for the year ended in August 2022, the largest over-the-year percentage increase since an 8.4% increase in October 1981. The above set of numbers point to an August YoY increase of core PCE of 4.75% compared to 4.56% over July. Data that will be released on September 29. We had an average month-on-month (MoM) increase of +0.35% over each of the past three months. The moment these MoM figures show a 0.0% MoM, we would already see core YoY PCE dropping below 2.00% by March 2023. At a +0.1% MoM rate, that moment is pushed out to May-June 2023. At +0.2%, we get +2.43% by end of 2023. At +0.3% every month, we merely drop to +3.66%, missing the FED target by a wide margin. However, these scenarios inform us that a disinflationary 2023 might be in the making. So, what is the tail risk?
The risks surface where monetary policy ends, and bad government policy starts. The pressure on political leadership is intensifying to show their hand and alleviate the inflation pain incurred by households and corporates. The eagerness to apply price controls on necessities like gas, electricity and food raises questions. Throughout history, we have evidence that price ceilings or price floors lead to suboptimal economic outcomes. Moreover, price controls aiming to attenuate, short-term inflation pains work counter to an objective of anchoring inflation over the long-term. How? By adopting a price ceiling, governments try to bypass the impact of high prices. Nevertheless, high prices have several functions. First, they allocate scarce goods and services to buyers who are most willing and able to pay for them. Second, they reveal a signal that a good or service is valued and that producers can profit by increasing the quantity supplied. The production process or supply is not obstructed, and higher quantities will push prices lower. Price controls can come at a high cost. The severity depends on the scope of controls and the degree to which it distorts the free-market price. Costs include higher government bureaucracy to enforce controls. Goods and services are allocated inefficiently across consumption and production. Competition shifts from production towards the political arena. Companies try to influence the (political) price setting process. The current debate among EU countries bears testament to this fact. The moment price controls are officialised, evasion thereof becomes widespread. During the early 1970s, the Nixon price controls led to an economy where inflation became unanchored whilst unemployment rose. The decade of stagflation was a fact. Price controls are to be avoided. Appropriate fiscal and monetary policy is what consumers and corporates deserve.
The US FED correctly tightens financial conditions in order to cool down aggregate demand and prevent a second-order wage-price inflation spiral. Expect a 75bp policy rate jump towards 3.00%-3.25% on September 21st. As we stated in previous notes, the FED is on autopilot and will not succumb until a clear inflation deceleration is visible. Market implied US policy rates have adjusted higher over the past week towards 4.25%-4.50% by February 2023. 10-year rates at 3.45% have priced that outcome. US equity and credit markets as well.
The question remains: what happens to 10-year rates, IG and HY credit spreads, the dollar index and US equity markets the moment the FED surprises to the upside and goes to, for instance, 5.25%-5.50%? That scenario might unfold when price controls make it through the legislative process. Will the above indicators all follow suit in line with the sensitivity to policy rates that they have shown so far? That might underestimate the complexity of this equation but also the ability of above indicators to look-through-the-cycle.
A 5.25%-5.50% policy rate might push 10-year rates towards 4.00%, as yield curve dynamics play-out. The dollar index (DXY index) currently at 110.00 might test the 121.02 high set over the summer of 2001. The dollar index made a low over 2008 at 70.68. The upward trend is still intact. The bottom over 2008-2009 coincides with the peak of globalisation in trade and finance. Evidence that we will reverse this multi-polar, protectionist and inward looking secular economic era any time soon is very limited to non-existent. With the continued tightening of USD liquidity, expect USD bond markets and USD derivate markets to keep USD demand high. Credit spreads might behave correctly, as the past decade has enabled corporate balance sheets to heal and get stronger across financial and non-financial sectors. Equity markets are jittery and nervous. The dispersion in valuation adjustments across sectors is high. But typically, equity markets require time to digest monetary policy hiking cycles. This warrants caution, as predicting the terminal FED policy rate is still too much guesswork at this juncture.
