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Inflation Cycles Down as Fed Stays Starstruck

The market’s been grappling with two issues – trade tensions and the Fed for a while now. ECRI’s cycle work speaks directly to the Fed debate.

Most economists, including those at the Fed, don’t understand that inflation is cyclical. So they end up using various excuses to explain the current inflation downturn that they didn’t see coming, having been transfixed by a 3.7% jobless rate (a 49-year low) and 3.1% wage growth (a 9½-year high).
The reality is that year-over-year (yoy) CPI growth, having peaked in July (long before crude oil prices did), fell in November to a ten-month low. Meanwhile, yoy PPI growth, also having peaked in July, dropped to a ten-month low. Both have rolled over, and remain in cyclical downturns (Chart 1).

Based on the downturn in our U.S. Future Inflation Gauge (USFIG), ECRI predicted this inflation cycle downturn back in the summer, before the bond gurus were pounding the table about the bond bear market. Sure enough, the market’s inflation expectations have plunged (Chart 2, bottom line). And, naturally, treasury yields are well off their highs.

Meanwhile, the USFIG remains in a cyclical downturn (top line). Thus, inflation is likely to ebb further in the coming months, confounding the consensus.

We’ll soon learn whether Chairman Powell intends to follow the late-1990s policy path he so lauded at Jackson Hole: “ʻLet's wait one more meeting; if there are clearer signs of inflation, we will commence tightening.ʼ Meeting after meeting, the Committee held off on rate increases while believing that signs of rising inflation would soon appear. And meeting after meeting, inflation gradually declined.”

Mr. Powell may not be aware of then-Fed Chairman Alan Greenspan’s February 1994 congressional testimony – referring to the decisive upturn in the USFIG – that "anything that [ECRI co-founder] Geoffrey Moore does I follow closely." In the late 1990s, as the USFIG remained subdued, the Fed held off from rate hikes despite “[c]onventional wisdom [that] still urged policymakers to respond preemptively to inflation risk – even when that risk was gleaned mainly from hazy, real-time assessments of the stars,” as Mr. Powell put it at Jackson Hole. He credited “Chairman Greenspan[’s] hunch that … improved productivity growth would allow faster output growth and lower unemployment, without serious inflation risks.” But that productivity growth remained robust for years, and doesn’t explain the Fed’s 1999-2000 rate hike cycle. The 1999 ramp-up in the USFIG does.
At Jackson Hole, Mr. Powell cautioned that “the conventional thinking” of “[n]avigating by the stars … has been quite challenging … because our best assessments of the location of the stars have been changing significantly.” Those so-called “stars” included "u star" (the natural rate of unemployment) and "r star" (the neutral interest rate).
Yet, in early October, his casual comment to Judy Woodruff that “we're a long way from neutral at this point, probably” – referring to the neutral interest rate – reinforced the suspicion that the Fed remained starstruck, and sent the markets tumbling – until the Fed followed up with a more circumspect statement.
If Mr. Powell genuinely believes what he said at Jackson Hole – that “the stars are sometimes far from where we perceive them to be” – the Fed will stop raising rates in the face of an inflation cycle downturn, coupled with a cyclical downswing in economic growth. But if the Fed stays starstruck – captive to the conventional thinking he questioned back in the summer – it will keep hiking.

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