Good Friday Morning! And happy Alabama hate week to all who celebrate. I know I have a readership in many states. Still, the Tennessee-Alabama game has the same feel as SEC Championship week or a Super Bowl. This state is all hyped up on Mt. Dew like Ricky Bobby’s kids, with everyone and their granny headed to Knoxville for that showdown. My mental state may be riding on the outcome of that game — Go Vols, in all things.
I debated whether or not to switch over to election coverage from here until November 8. I’m putting that off for a week with the latest CPI report. I wanted to cover one of the hottest debates over inflation, which will dominate the economic discussion post-election. The next major economic report we get is the Q3 GDP report on October 27. That report is expected to be positive, for better or worse, depending on how the Fed views it. More on inflation is below; links to follow.
Where you can find me this week
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[10/10/2022] The left wants everyone to suffer in the dark for “energy sobriety” – Conservative Institute
[10/14/2022] Democrats reek of desperation with January 6 subpoena of Trump – Conservative Institute
The trillion dollar question: how far does the Fed need to raise rates?
October 13, 2022, Thursday morning, the latest CPI report dropped from the Bureau of Labor Statistics, showing everyone that inflation was still running much hotter than expected. Predictably, stock futures plummeted, and markets showed a slump across the board for the first hour of trading. And then, unpredictably, markets roared to life and rocketed up. WSJ:
Stocks had tumbled in early trading after new data showed that inflation remains persistently high, strengthening expectations for continued large interest-rate increases from the Federal Reserve. At their lows, the Nasdaq was down more than 3%, the S&P 500 had dropped more than 2%, and the Dow had declined nearly 2%, according to Dow Jones Market Data.
The Dow ended the day up 827.87 points, or 2.8%, to 30038.72, its largest one-day percentage gain since November 2020. The S&P 500 rose 92.88 points, or 2.6%, to 3669.91. The tech-heavy Nasdaq Composite advanced 232.05 points, or 2.2%, to 10649.15.
I had CNBC on in the background as this rapid resurgence happened. The intraday high hit something around 950-960 points in the Dow. Everyone had the same reaction: what on earth is happening? Stocks climbing like that don’t align with the data we just received.
The “why” and “how” were less intriguing than the historical parallel. On October 13, 2008, the markets had, at the time, the largest one-day surge ever. The front page of the New York Post read: “HOLY DOW – Best day ever as re$cue takes hold.” The story read:
The stock market rocketed to its biggest one-day points gain ever yesterday – reversing a string of huge losses – as investors finally began believing that the global financial rescue could succeed.
The Dow Jones industrial average soared a remarkable 936.42 points, to close at 9,387.61, easily smashing the blue-chip stock index’s prior one-day record points gain of 499, set in 2000. The Dow’s 11.08 percent jump was its biggest in 75 years.
The Wilshire 5000 – the broadest stock-market index – posted its biggest percentage increase ever, with an 11.4 percent spike.
“Sometime last week, it seemed like we faced Armageddon, so to have a coordinated plan on stabilizing banks is huge progress,” said Jack Ablin, chief investment officer at Harris Private Bank in Chicago.
That rally happened after George W. Bush and the Treasury Department announced a plan to buy $700 million in US Treasuries. It was a Wall Street bailout meant to stabilize the financial system. Two days later, the bottom fell out in markets, giving up everything, and we had an absolute panic. There’s a funny Paul Krugman blog item (also headlined “Holy Dow!”) where he was talking about that miraculous rally on October 13, 2008. After the collapse started again, he wrote, “And while I was writing the little note below, the bottom dropped out ….”
So it goes.
I’m not saying we’re at October 13, 2008, in the current moment (though markets doing the same jump 14 years later is interesting). But it’s wise to never read too much into day-to-day market swings, up or down. The bottom of the 07/08 crisis would end up getting priced near the spring/early summer of 2009.
As the WSJ noted in its coverage this week, “such moves—sharp gains as well as steep drops—can be a sign of trouble.” We experienced this during the pandemic, the 2018 QE taper, and consistently during the 07/08 Great Financial Crisis. Spikes like this are volatility and a sign of unhealthy markets.
Back on topic, I wrote all that to say that the market swings don’t matter that much. On the other hand, the CPI report is deeply significant, as is the debate it is spurring among important academics trying to sway the Federal Reserve’s decision-making.
There was nothing good about this report; it came in hotter than expected and will encourage more rate hikes. BLS Link. I’m going to hone in on a few items. If you believe some of these categories should be higher — that may be because this only captures increases over the last 12 months, and we’ve had inflation for more than 18 months.
- Headline CPI: 8.2% inflation over the last 12 months across all items.
- Food was a major driver. All food at home is up 13% over the last year. Food away from home is up 8.5% over that same period of time.
- General food category increases over the last year:
- Cereals and bakery products – 16.2%
- Meat, poultry, fish, and eggs – 9%
- Dairy and related products – 15.9%
- Fruit and vegetables – 10.4%
- Non-alcoholic drinks and materials – 12.9%
- Other food at home – 15.7%
- Specific food item increases over the last year:
- Flour and prepared mixes – 24.2%
- Breakfast cereal – 16.6%
- Rice, pasta, cornmeal – 15.9%
- Bread – 14.7%
- Cookies – 15.7%
- Crackers, bread, and cracker products – 16.4%
- Breakfast sausage – 14.7%
- Hotdogs – 16.5%
- Lunchmeats – 17.0%
- Whole chickens – 14.9%
- Chicken parts – 18.4%
- Eggs – 30.5%
- Milk – 15.2%
- Cheese – 13.4%
- Ice cream – 13.6%
- Potatoes – 17.5%
- Lettuce – 15.7%
- Canned fruits/vegetables – 19.0%
- Frozen fruits/vegatables – 14.1%
- Butter – 26.6%
- Margarine – 44.0%
- Salad dressing – 15.2%
- Peanut butter – 11.2%
- Soups – 20.5%
- Spices / Seasoning – 13.8%
- Olives / pickles / relishes – 17.4%
- Baby food – 11.8%
- General food category increases over the last year:
- Energy: Gas continued to drop last month, so energy as a component of the CPI index is dropping. Caveats to that: Natural gas is up 2.9% over the month, and electricity is up 0.4%. Specific categories:
- Fuel oil: +58.1%
- Propane/kerosene/firewood: +12.8%
- Gas all-types: +18.2%
- Regular gas: +18%
- Midgrade gas: +18.3%
- Premium gas: +19.4%
- Electricity: +15.5%
- Utility gas service: +33.1%
- Other items: Core inflation is up 6.6% over the past 12 months, the largest 12- month increase in that index since August 1982 (we’ll return to this number). The shelter index also rose 6.6% over the last year, accounting for over 40% of the total increase in all items less food and energy. Other indexes with notable increases over the last year include medical care (+6.0%), household furnishings and operations (+9.3%), new vehicles (+9.4%), and used cars and trucks (+7.2%).
I wanted to break down some of the individual categories in this report because I often get the question: “Inflation just feels much higher than the number they put out.” The reason that’s the case is that the CPI Index is a weighted index, and not every item gets weighted the same. Some things have risen astronomically — like fuel oil (58.1%), airline fares (42.9%), or margarine (44%) — but other items are much smaller.
For instance, in the weighted index, food makes up 13.635% of the pie. The Federal Reserve pays more attention to “core inflation.” That’s everything minus food and energy costs. Because food and energy costs can be volatile, removing them can give you a better idea of underlying inflation. I have a love-hate relationship with that measure, but I get why it exists. Food and energy alone can sink your re-election odds if you’re a politician. The price of bread has sunk many kings.
But when it comes to deciding whether or not to raise interest rates at the Fed, you want to make that decision based on core inflation because it’s less volatile and more sticky (meaning those price hikes are more likely to stay, unlike the shifting prices of food and gas). Of all the measures the Federal Reserve is watching, the two that concern it most is core inflation and a wage/employment spiral.
We’re going to focus on core inflation. It’s sitting at the highest level since 1982 at 6.6%. One of the most significant components of core inflation is housing, which is rising due to mortgage rates and rental costs.
Outside of the stupid debates you’ll see on networks like CNBC about whether or not we’ve hit “peak inflation,” the central factor driving the debate at the Federal Reserve is how to reduce core inflation. The primary tool at the Fed’s disposal is raising interest rates. The question is this: how much do you have to raise interest rates to bring inflation under control?
There are two camps to this debate. On one side is Lawrence Summers, representing the most hawkish view. Summers tweeted a thread about this theory a few days ago here. The gist of his point comes down to the last two points:
Our models suggest that unless the rest of the core basket moves sharply below the 2% target, core CPI inflation will stay above 4% until late 2023.
Inflation has never come down without the Fed bringing the funds rate above core inflation. Such necessary tightening has historically been followed by a recession and an increase in the unemployment rate of at least 2.5 percentage points.
The funds rate is where the Federal Reserve sets interest rates (for how that works, read this piece). When you read stories about how the Federal Reserve increases interest rates by 75 basis points, they raise the fund rates. The higher the funds rate, the higher the interest rate are for everything else. Currently, the fund rate is 3.00 – 3.25%, as set by the most recent Federal Reserve meeting.
In contrast, core inflation sits at 6.6% in this week’s CPI report. To tackle inflation and bring it down, Summers says the Federal Reserve has to raise interest rates above 6.6% to combat inflation. He’s speaking historically; this is what the Federal Reserve has always had to do. Realize for a moment that conclusion of this argument means the Fed has to more than double the current funds rate to accomplish that feat.
Realize this as well: a Fed funds rate of more than 6% is not priced into the market in any way. The WSJ reports, “After Thursday morning’s report, investors in interest-rate futures markets anticipated the Fed would raise interest rates to just below 5% by March, according to CME Group. On Wednesday, investors expected the Fed to raise rates to peak at just above 4.5% in February.”
Investors expect more rate hikes but hope to go no further than 5%. Markets are hoping that the Fed hikes will stop by next March. In fairness to markets, the meeting minutes from the Federal Reserve have suggested that 5% may be the peak of rate hikes.
But what if we get to 5% as the Fed projects and core inflation continues rising? In fact, we should expect core inflation to continue growing. Summers makes a point in his thread: his model suggests core inflation will peak in early 2023 and then remain elevated throughout the year. That’s why he says that historically, there’s only one way to achieve lower inflation by bringing interest rates above the core inflation number.
Look around you now, and realize that all the chaos rippling throughout markets is because the Federal Reserve is rapidly raising interest rates at the fastest pace in its history. Furthermore, if Summers is correct, we’re barely halfway to where we need to be.
The flip side of this argument comes from Jeremy Siegel, professor of finance at the Wharton School. He was on CNBC after the inflation report dropped and was adamant that the Fed has to stop. His interview is here.
Siegel’s point is that inflation has stopped, and the Federal Reserve is going too far. He asserts that inflation will come down without the Federal Reserve going that far. And most importantly, he firmly claims that if the Federal Reserve makes the march to something north of 5%, it will drive the US economy into a depression.
His concern is that the Federal Reserve relies on outdated information and will raise rates based on months or years-old data. On this issue, he has a point. We know that things like housing costs in the CPI report are delayed, and Summers would agree with this point. It could take all of next year for the housing cost increases to work through CPI unless we see a serious drop in housing prices in the next few months.
I know how the Federal Reserve would counter Siegel’s point. They’re looking at history, too, similar to Summers. In an interview, Neel Kashkari said:
“The one mistake that I’m acutely aware of—that I want to avoid repeating from the 1970s—is when policy makers saw the economy weakening, saw inflation start to tick down, and then they cut rates, thinking they had done the job. And then inflation flared back up again—that, I believe, is a mistake we cannot make and will not make,” Mr. Kashkari said Tuesday during an online event hosted by The Wall Street Journal.
Powell has used this example, too, in his interviews and Q&A sessions. Do you know what’s worse than causing a recession due to interest rates being too high? Cutting rates too soon and allowing inflation to run even hotter, which is what happened in the 1970s. That issue wasn’t fixed until 1982-83 after the double-dip recession and Reagan’s supply-side policies kicked in.
The academic debate is fascinating to watch and read. The question I keep pondering is this: who does that Federal Reserve sound more like, Lawrence Summers or Jeremy Siegel? They sound like Summers. The Fed has not said they’ll raise rates above the core inflation target, but they must be hoping that number moderates soon.
There’s a real chance we’ll see core inflation rise above 7% before March 2023. If that’s the peak, and it stays elevated in 2023, will a 5% funds rate be enough to bring inflation down? Likewise, what happens if we see a surge in oil/gas prices (and food) before that time? That will bring new pressure on headline CPI numbers, pressuring the Fed to raise rates more.
No one has a comfortable answer here. The threats are explicit: lower rates too quickly, and inflation goes back up; raise rates too high, and you trigger a recession. And if you initiate a deep enough recession, cutting interest rates in response to it likely won’t be enough to jump-start the economy. We’ll be back in the 2008 situation of bailouts.
The Austrian/Hayekian philosophy student in me comes out on this last point. The economy is not some machine where you pull levers and fix things. The economy is organic, and if you torch one segment of it, how it grows back will look and act differently. If you cut a tree limb off, you can’t magically grow it back the same; new growth will have to take its place.
Whatever I don’t know, I do know this: if the Fed knew what interest rate would bring inflation down, they’d have announced it by now. They don’t know it. That leaves a lot of guesswork in the interim.
Links of the week
The Regulators of Facebook, Google and Amazon Also Invest in the Companies’ Stocks: The Federal Trade Commission’s officials traded stocks and funds more than those at any other major agency, including going heavily into tech shares – The Wall Street Journal
Rail union rejects labor deal brokered by Biden administration, raising possibility of strike: “Railroaders do not feel valued,” said Tony D. Cardwell, president of the Brotherhood of Maintenance of Way Employes union. – NBC News
Democrats Made Their Bed – Noah Rothman, Commentary Magazine
Old Man Biden – Matthew Continetti, Commentary Magazine
People in Poland Are Burning Trash to Stay Warm This Winter: Russia’s war in Ukraine has exposed the vulnerability of Europe’s fuel supplies. In Poland, some households are hoarding garbage to replace their coal. – Bloomberg
Get ready for higher heating bills across the US – Wall Street Journal
Romney’s Non-endorsement of Mike Lee Is Self-Undermining – Fred Bauer, National Review
Why Greens Love Putin – Emmet Penney, Compact Magazine
Babies born during coronavirus lockdowns developed communication skills at slower rate: The study suggests that babies born during lockdowns learned words and pointed at objects at a slower rate. – Fox News
Perfect storm in Oregon could pave way for Republican governor – Washington Examiner
Twitter Thread(s) of the week
Satire of the week
I conscientiously object to learning Microsoft Teams – Duffel Blog
American Sheriff from Cabot Cove Arrives In Cork To Investigate Local Woman’s Death – Waterford Whispers News
Thanks for reading!