With many grocery and other consumer prices surging, the Federal Reserve is under increasing pressure to tighten policy aggressively. Here, a Safeway supermarket in Scottsdale, Ariz., on a recent day.
Ash Ponders/Bloomberg
A fresh 40-year high in consumer price inflation has Wall Street ringing alarm bells and investors increasingly sure the Federal Reserve will raise interest rates by a half-point when policy makers meet next month—or maybe sooner. What happens from there just got even harder to predict.
The January consumer-price index confirmed what consumers have known for some time. Prices are rising across the economy, and fast, with the overall index up 7.5% from a year ago from a 7% pace in December. The narrative around reopening bottlenecks keeping inflation contained, if persistent, within a tight group of predictable, pandemic-affected areas has been stale for some time; January’s report makes it worth shredding. From a year earlier, bread, meat, and eggs rose by double digits, gasoline surged 40%, and even banking services jumped 14%. As Grant Thornton chief economist Diane Swonk put it: “The only thing that looks like a good deal is ice cream.”
After the hot CPI data hit, CME data showed traders swiftly priced in a 96% chance that the Fed hikes by 0.50% in March, as opposed to a 0.25% increase. A day earlier, the probability of a half-point hike was at 24%; a month earlier, it was at 7%. Odds slipped a day after the CPI data but remained elevated.
Comments from St. Louis Fed President James Bullard, a voting member this year for the Fed’s policy-setting arm, helped fuel the rapid shift in expectations. “I’d like to see 100 basis points in the bag by July 1,” Bullard said in an interview with Bloomberg News. “I was already more hawkish but I have pulled up dramatically what I think the committee should do.” The question, of course, is whether Bullard’s updated view is shared by his colleagues.
As traders scrambled to reprice rate hikes, so did Wall Street economists. Goldman Sachs changed its rate projection to seven from five quarter-point increases this year, and three next. Deutsche Bank now similarly sees 1.75% by year end, starting with a half-point increase.
But what comes after an increasingly possible 0.5% rate increase in March? Does it suggest similarly sized and/or consecutive hikes in subsequent meetings, or will front-loading mean less pain? What does it mean for quantitative tightening, or the reversal of some of the trillions in emergency bond buying, over the past two years? And does it mean a Fed finally fighting to move from behind the curve makes a recession inevitable?
With those questions in mind, we are interested in two obscure measures shared with Barron’s this past week by Matthew Luzzetti, chief U.S. economist at Deutsche Bank.
Here’s the first one. Everyone knows consumers have been miserable as the cost of almost everything keeps rising, product sizes are shrinking, and shortages abound. The most recent consumer confidence reading from the University of Michigan showed respondents’ views of current conditions are at the lowest level since 2011, while expectations for the future fell back to early-pandemic levels.
But it’s much worse than that. Luzzetti says his favorite confidence gauge is the spread between the present-conditions readings in the University of Michigan and Conference Board surveys. Because of differences in methodologies, there is a cyclical spread that opens up between the two, he says, as the Conference Board’s measure is dominated by lagging indicators which outperform late in a cycle relative to the Michigan data. The consumer-sentiment gap is now at the lowest level in more than 50 years, signaling consumers are more pessimistic than they have been since the 1960s.
Luzzetti says the confidence gap is about 80% correlated with common measures of the yield-curve slope, such as the gap between 10-year and two-year Treasury yields. The most direct implication, then, is that the yield-curve slope should be significantly flatter—a takeaway that Luzzetti says fits with his view that the Fed is likely to tighten faster than markets have appreciated. The gap is also flashing elevated recession risks, with the probability of a recession about 50% over the next year.
The second indicator is more abstract. Deutsche Bank’s own “shadow” fed funds rate attempts to capture the overall stance of monetary policy by factoring in unconventional tools, such as large-scale Treasury and mortgage-backed securities purchases. Although the Fed is in theory still easing, given that the tapering of $120 billion in monthly purchases isn’t yet complete, Luzzetti says his shadow rate has risen 0.85% over the past three months. For context, that increase ranks in the top 5% of historical moves relative to the fed funds rate.
The idea: By virtue of faster tapering and tougher rhetoric, the Fed has already started the tightening process. Shadow interest rates, when accounting for the effect of quantitative easing, aren’t as negative as they were a few months ago, when Deutsche Bank’s model was around minus 1% and the Atlanta Fed’s Wu-Xia shadow rate was about minus 2%. (Luzzetti notes these shadow rates are nominal, or not inflation-adjusted.)
Luzzetti says that before the January CPI hit, his shadow rate meant talks of a 0.5% March increase were overblown and markets may have been ahead of themselves in terms of tightening expectations. The January CPI overturned that immediate logic, but there is still a bigger-picture takeaway. If shadow rates continue to rise dramatically, they may signal that the Fed has less overall tightening to do, via both rates and balance-sheet shrinkage, than investors think. The reverse, of course, is also true.
Write to Lisa Beilfuss at [email protected]
