The Fed Can't Whip Inflation Alone
Wednesday's U.S. inflation numbers came in higher than Wall Street economists' expectations, with the overall Consumer Price Index rising a shocking 9.1% over the past twelve months. Total inflation surged in June, up a dramatic 1.3% on a month-to-month basis compared to a 1.0% rise in May. Prices minus food and energy, or core inflation, were more restrained, rising 5.9% for the trailing 12 months, and accelerating just slightly from 0.6% in May to 0.7% in June.
Financial markets dropped on the news, but fairly modestly: The Dow Jones and Nasdaq Composite indexes were both off less than 1% Wednesday morning. That's partly because the Biden White House already signaled the high print yesterday, nudging equity indexes down a bit under 1% before the July 11 close.
Crypto responded a good bit more dramatically, with bitcoin (BTC) slashing more than 3% immediately on the CPI figures and ether (ETH) bleeding more than 4%. This more reflexive nature of crypto likely reflects a couple of things: the assets' more speculative nature makes it more vulnerable to rate hikes, and crypto's greater concentration among retail holders may mean there's generally less foresight in the market.
Inflation is bad for an economy for a lot of reasons. Most fundamentally, inflation creates uncertainty among investors and spenders because it makes it harder to plan ahead.
But financial markets, whether crypto or equity, are generally less worried about inflation's direct impact on Main Street than about the Federal Reserve's response via the money supply, aka its overnight interest rate. The muted equities drop so far, even on higher-than-expected numbers, reflects that the Fed has already announced an aggressive schedule of interest rate hikes, plans that have already pushed equity markets down nearly 15% since their January peak. In the parlance, even a higher-than-expected CPI result was to some extent already "priced in."
One takeaway is that markets seem primed for significant bumps if future CPI numbers come in under expectations. A deeper look at Wednesday's numbers, and at the real world, suggest we could indeed begin to see the inflation curve bending back towards earth.
Above all, that's because about half of the top-line inflation came from one source: fossil fuels. Other categories are elevated: food, for instance, saw a 1% monthly rise vs. 0.5% in December of last year. But energy categories have skyrocketed: Gasoline went from a 1.3% monthly rise in December to 11.2% in June. The price of home natural gas actually flipped from a 0.3% decline in December to an 8.2% rise in June.
That's likely a product of the Russian invasion of Ukraine and accompanying sanctions against Russian oil. The same factor would indirectly drive food and other inflation because petroleum and gas impact other costs in the form of things like transportation, plastics and fertilizer.
Is the inflation curve already bending?
The good news, as the Biden White House took pains to highlight Tuesday ahead of the CPI numbers, is that gasoline prices have declined since the June data was compiled. U.S. prices at the pump have dropped for 28 days in a row, from a peak national average of $4.92 per gallon on June 1 down to $4.62 today, according to GasBuddy data. That's still massively up from an average of $3.16 in June of last year, and prices for refined gasoline don't entirely track natural gas or overall energy prices. But the bending gasoline curve could be a big indicator that overall inflation is actually leveling off or even dropping as you read this.
Prices of other significant upstream commodities have also moderated, notably including wheat and copper. On the one hand, that's incredibly good news. The war in Ukraine in particular had raised early worries of a massive global food shortage, but after spiking in March wheat prices are moving significantly back towards prewar levels. There has already been significant damage, particularly in Sri Lanka. But if prices keep correcting, we may dodge (for now) the worst-case scenario for the developing world.
Under normal circumstances, declining commodity prices would have an ominous downside, suggesting macroeconomic weakness or a looming global downturn. Some bears are making that case now, but I think it's a mistake. Remember, we're coming down from elevated prices between January and June. Dropping commodity prices right now are less about a macro recession and more about reversion to the mean after a period of uncertainty. (Similarly, a dropping stock market does not directly reflect the real economy.)
It's not just the money printer
Finally, those granular numbers also highlight a certain degree of absurdity in the Fed's role as arbiter of U.S. (and to an extent global) price levels.
In a perfect world, the focus of the current crisis would be on policy intended to fight rising energy prices, including things like national conservation programs. The Biden administration has made some moves to address this specific issue, including releasing strategic petroleum reserves and using the bully pulpit to pressure refiners to cut gas prices.
But those are piddling steps compared to the power of Fed rate setting. The problem, of course, is that rate setting is an entirely untargeted yoke on the economy and will constrain demand not just for fossil fuels but for everything.
In some sense it's not as much of a blind misstep as it might seem because there are plenty of non-inflation reasons to lift interest rates: Rates too close to zero have dangerous implications for resource and risk allocation. A significant part of the current deflation of equity and crypto markets alike was set up by years of very low interest rates leading to misallocation of capital. Raising rates now should, in theory, help set up a more careful future investing environment.
Nonetheless, we can't continue to rely on the Fed's mathematical levers to fix challenges in the real economy – or to simplistically blame money printing for inflation. There are a lot of other factors, and the solutions are more about real-world policy than blanket financial re-engineering.
I know that first hand because I live in New York City, where we're not reliant on automotive transportation and where power providers have pursued non-fossil fuel energy sources over the long term. This is strictly anecdotal, and I do hate to rub it in, but my transportation costs and rent have not gone up at all over the past three years and my electric bill is up only modestly.
I'm living with the same Fed as the rest of the U.S., but things other than the money supply do in fact matter.
- David Z Morris
