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Markets Are Betting That Inflation Is Collapsing

Published on: Aug 31 2022

In the July issue, I asked, “Which will break first: inflation, the economy, or the Federal Reserve?” Futures market prices indicate, as they have all year, that investors expect inflation to fall to the Fed’s target after modest interest rate increases and without triggering a recession or reduction in earnings growth.

The July Consumer Price Index (CPI) report seemed to sup- port that view. The CPI was unchanged from June to July (0% inflation), and the 12-month inflation rate fell from 9.1% to 8.5%.

The lower CPI was expected. I’ve said for several months that the CPI would peak over the summer. But that doesn’t mean it will soon fall into the Federal Reserve’s target range.

The decline in the CPI was due mostly to lower prices for energy and other commodities. Demand declined, and some of the supply issues have been resolved or reduced. But other inflationary pressures continue. The most prominent is the strong demand for labor.

The economy continues to create a high number of new jobs, and there are far more job openings than there are people out of work and looking for jobs. The result is high wage growth that largely is passed through to consumers as higher prices. We can see the effects in the details of recent CPI reports.

Price increases for services, especially cyclical services, continue to increase well above the Fed’s target inflation rate. (Though wage growth is high, it still has been lower than inflation, resulting in a decline in real wages.)

Higher wage growth supports continued strong demand for both goods and services and pressure for higher prices. Lower demand for goods and services is needed to reduce the inflationary pressures, and a recession almost always is needed to reduce inflation from recent levels to the Fed’s target. Recent gross domestic product (GDP) reports caused many people to conclude the economy is in a recession.

The popular definition of recession is two consecutive quarters of negative growth. GDP growth was reported as negative for the first and second quarters of 2022. But the popular definition isn’t accurate. GDP accounting measures only final goods and services, not all the intermediate activity that generates the final goods and services.

Plus, GDP accounting distorts how changes in inventories and imports affect economic growth. The negative growth in the first two quarters was due largely to changes in inventories and imports, not real economic activity.

The economy is stronger than the GDP data suggest. It is likely that to bring inflation near its target, the Fed will have to tighten monetary policy enough to trigger a recession or something close to it. While most analysts focus on interest rates, the Fed’s reduction in its balance sheet, as reflected in the monetary base, is more powerful and continues.

Yet, stock market prices show no expectation of slower economic growth. The decline in stock prices in 2022 mostly matches a revaluation of stocks because of higher interest rates.

While stock valuations are below their highs of the last few years, they’re still historically high and have increased since mid-June. Only recently have we seen the first acknowledgements that economic growth might slow. Analysts estimates of future earnings began to be reduced in the last month or so.

In their latest earnings reports, some key companies reported that they were more pessimistic about the outlook for the rest of 2022. But the possibility the Fed might tighten policy enough to reduce growth or cause a recession isn’t reflected in stock prices. Stock investors believe the decline in energy prices and resolution of some supply issues is sufficient to bring inflation to the Fed’s target.

I believe the potential economic and investment outcomes over the next year are as varied and uncertain as at almost any other time. Instead of being positioned for one scenario, I recommend having a balanced portfolio that will hold up well in most environments.

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