Wednesday, September 14, 2022

Inflation Surpises To The Upside - Yet Again

Markets plunged yesterday on the news that headline and core inflation in the US fell only by a tiny bit, much less than markets had hoped for and optimistically priced in.  My post yesterday (before the CPI numbers came out) went into why inflation is not going to go away any time soon, at least not without a massive, deflationary asset price correction, aka a Crash (capitalized on purpose to denote massiveness in the style of 1929 or 1987).

Historically, Crashes only happen when two conditions are met, concurrently:

  1. A prior new all time high marked by extreme optimism by professionals and the madness of crowds, who come late to the party.
  2. A credit crunch which makes liquid money very scarce and expensive to use for market leverage.  
The first condition has certainly been met, but not the second - at least not yet and not as much as necessary to force massive margin call liquidations, which is the prime cause of all Crashes. 

The Fed has raised rates off the bottom and seems - finally - determined to raise them even further.  But, rates are still very far from becoming a true inhibiting factor for consumer behavior. Real rates are still very, very negative and must go closer to zero before they have any serious impact on inflation - see chart below.  Right now the national average interest rate for savings accounts is a puny 0.13%. The American consumer is therefore strongly incentivized to consume even more, instead of saving. 

2 Year Treasury Minus CPI Inflation

With inflation at 8.3% market rates for the 2 year Treasury should go to around 8% from 3.8% today - or inflation has to come down to approx. 4% by other means (ie recession or Crash).

But, it is not only interest rates which determine liquidity conditions: the most important factor is the amount of money available in the system.  In this regard, the Fed is still dragging its feet;  its balance sheet is still extremely bloated and will continue to be for a long time, even as it ramps up QT to a maximum $95 billion per month starting in September - see chart below.

Fed Balance Sheet Is Still Hugely Bloated

For perspective, in 2009 Fed assets were "just" $1 trillion and in 2019 "just" $4 trillion compared to today's massive $9 trillion. This deluge of liquidity caused asset price bloat for years and, eventually, resulted in today's spike in consumer inflation.  

The Fed is, thus, faced with a stark choice: in order to seriously attack inflation it has to raise rates AND reduce liquidity very substantially.  Doing so will cause a recession and could precipitate a market Crash.  Not easy to do, particularly just before mid-term elections in November which may result in Republicans regaining firm control of Congress.

What will the Fed do? I think it will continue raising rates while keeping QT at today's levels for a few more months, erring on the side of liquidity caution.  I can't really blame them, they are politically appointed policy boffins, not independent, hard-headed business leaders.

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