WITH THE inflation crisis well into its second year, a few words have cemented their place in the lexicon of investors. There were the subsequently much-derided predictions of a “transitory” problem. There were also the accurate forecasts of interest-rate “front-loading” by central banks and, more recently, grumbling about the belatedly “expeditious” manner in which America’s Federal Reserve has approached tightening. Attention now is on the concept of the “head fake”: the notion that a rosy batch of data suggestive of receding inflation can fuel a burst of optimism in markets, only for the dreary reality of persistent price pressures to reassert itself.
At the tail end of last week, beleaguered asset prices soared, buoyed by America’s latest inflation numbers. Stocks rallied around the world. The NASDAQ, America’s tech-heavy benchmark, climbed by nearly 10% on November 10th and 11th, its strongest two-day rally in more than a decade. Beaten-down currencies such as the pound and yen also rebounded. Economists had expected America’s consumer price index (CPI) for the month of October to increase by 0.6% from a month earlier. Instead, according to figures released on November 10th, it rose by 0.4%. That is a small difference in the grand scheme of things. On an annualised basis, it equates to inflation of nearly 5%, well above the Fed’s target of roughly 2%. But investors were quick to extrapolate to the possibility that maybe—just maybe—inflation’s grip on the American economy was weakening.
Almost instantly traders revised down their estimates for the peak of interest rates. Before the release, many thought the Fed would lift rates to 5.5% by the middle of 2023. Now bond yields suggest 5% is more likely. That would have all kinds of positive consequences. It would reduce the likelihood of a crushing recession in America and beyond, ease the pressure on other countries’ central banks to keep pace with the Fed and boost the prices of risky assets, especially stocks.
Hence the question about whether the data amount to a head fake. After all, investors were burned in autumn last year, when inflation briefly appeared to top out, and again this July, when they concluded prematurely that the Fed was going to reduce the intensity of its tightening. On both occasions market rallies fizzled out in short order.
Is this time different? The case that price relief is finally at hand rests on two pillars. First, a wide array of products appear to have moved towards deflation. The prices of core goods—excluding volatile food and energy items—fell by 0.4% month on month in October. Some of this reflects the unwinding of pandemic-era price surges, such as those for used cars. But declines were broad: household furnishings, clothing and school supplies all got cheaper. And retailers report higher inventories and somewhat softer consumer demand. The net effect appears to be a long-awaited decline in goods prices.
The second pillar is a tantalising hint that prices for services are also heading in the right direction. The single biggest driver of services inflation—the cost of housing—looks like it is losing a little oomph. The most important factor in determining housing costs in CPI is rents, which accounted for more than half of the increase in core inflation in the past few months. In October rents rose by 0.7% month on month, down from 0.8% in September. That is significant because it suggests official estimates are tracking in the same direction as higher frequency private-sector gauges, which have shown deceleration in rental inflation for nearly half a year. A basic difference in methodology explains the gap: private-sector gauges look at the asking price for properties on the market, whereas the official measure looks at rents actually paid by tenants, including those on existing, often cheaper leases. Allowing for that long lag, rents may be on the cusp of becoming a force for disinflation in the CPI.
A reality check is useful, however. As the experience of the past year shows, monthly figures can be noisy. And the fundamental problem in America is excessive demand relative to supply. This is now most acute in the labour market, where extremely high job vacancies underpin hefty wage increases. To rein in inflation, the labour market needs to cool.
The economy is well past the point of being able to enjoy disinflation without collateral damage. It is theoretically possible companies could pare back their hiring without pushing huge numbers onto the dole. Yet some increase in unemployment seems inevitable and, for the Fed, even desirable.
What is more, the stock rally is unwelcome from the Fed’s point of view. Markets are the primary transmission belt for monetary policy. A large increase in stock prices represents a loosening of financial conditions, which if sustained would make it easier for companies to obtain credit, running counter to the central bank’s efforts. Fed officials are deeply versed in the history of the 1970s, when America struggled with double-digit inflation, and when central bankers erred by relaxing policy as soon as pressures started to ease—something that allowed inflation to roar back.
Jerome Powell, the Fed’s chairman, is determined to avoid a similar mistake. At a press conference on November 2nd, after the latest rate rise, he said no fewer than four times that the Fed still has some “ways to go”. That ought to serve as a warning for investors suddenly giddy with optimism. Even if the lower-than-expected inflation reading does mark a turning point in America’s battle against inflation, it will be a gradual turn, not a sharp reversal.■
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