The Fed’s Clever Misdirection

If you were playing a drinking game this morning keying off the word “transitory” you’d have passed out by now.

Seemingly everyone is talking about inflation these days. They all want to know whether inflation will be transitory (as Jerome Powell repeatedly insists) or persistent. When it comes to markets, this is the wrong question. I’ll explain.

The federal government threw ordinary Americans under the bus 40 years ago when it began altering the process by which inflation is measured and reported [for more, read John Williams’ excellent primer HERE.]  Cost of living increases (and interest rates) have been tied to this muted CPI data, meaning that consumers have had trouble keeping up with actual increases in rent, food, gas, medical care, etc. which have run about 10% lately. It’s a key reason the middle class has been steadily shrinking.

If the Fed/government were determined to keep actual inflation at or near 2%, they would simply limit the increases in oil/gas prices which are largely to blame for runaway inflation as they’ve done quite successfully in the past.

Since CPI data collection and reporting has become so convoluted, though, the MoM and YoY increases in oil/gas prices have been the primary drivers behind the reflation narrative which is responsible for this past year’s margin expansion/recovery. In other words, the Fed has needed these sharp rises in energy prices to avoid disappointingly low inflation.The other issue, of course, is that stock market performance is joined at the hip with oil and gas prices. Crash them, as was done in late 2018 or early 2020, and you’re likely staring down the barrel of a equities correction.

Let them spike higher, though, and you run the risk of soaring inflation and interest rates. At least that’s the way it used to work.

Over the past 10 years, however, there have been many disconnects. Importantly, they have much less to do with the ebbs and flows of economic activity than they do with managing (usually suppressing) interest rates.

Regular readers know that the Fed now faces an important test. Thanks to last year’s crash, April’s YoY increase in gasoline prices should be around 60% and that (after averaging 1.2% since the May 2020 lows) CPI could top 3-3.5%. What might this do to interest rates?

CPI has climbed nearly back to its 2018 highs. But, despite quadrupling over the past year at a rate of increase which has never been seen in our lifetimes……10Y yields (1.6%) are still less than half their 2018 highs (3.25%.) How could this be? Hint: it’s not because the increase in inflation is transitory.

Here’s another little hint.

Bottom line, whether or not inflation is transitory doesn’t matter nearly as much as whether or not the Fed can convince bond investors algos to ignore the sharp rise in inflation that will be reported in two weeks.

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The 10Y has been vitally important to markets and the Fed. So, it wasn’t about to leave things to chance, for instance, when it nearly broke out of a very long-term channel in October 2018. As we expected, oil/gas prices not so mysteriously crashed in the nick of time – causing interest rates to also crater.continued for members…


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