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Peak Inflation Is More Bad News Than Good News Right Now

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EDITOR'S NOTE: Just because CPI and PPI inflation data matched what analysts were expecting doesn’t mean their forecasts were right on the track or that inflation may somehow succumb to their economic models. What of the months where their outlook was dead wrong? So, inflation matched consensus expectations. Does this give forecasters the green light to claim we are at “peak inflation”? Bear in mind that inflation doesn’t always follow a linear path. In 1970, the rate was at 5.8%; in 1972, it declined to 3.3%. In 1974 it surged to 11.1% only to ease back to 5.7% in 1976. Then in 1980, it peaked at 13.5%. We don’t know which forecasts matched analyst expectations then, but again, it didn’t really matter. The purchasing power of the dollar netted a devastating decline. So, the CPI and PPI showed increases that were only as bad as analysts had hoped. Amid global uncertainties, especially with regard to Russia’s war and China’s latest pandemic lockdown, what other factors can derail economists’ estimates which in the last two years have failed at every turn?

Peak inflation is more bad news than good news right now.

The peak inflation narrative is in full swing following the release of the March Consumer Price Index (CPI) and Producer Price Index (PPI) reports. Each was awful from an inflation reading standpoint, which is part and parcel why there is such an earnest desire to believe that they are as bad as it is going to get.

Briefly, CPI was up 8.5% year-over-year and core CPI was up 6.5% year-over-year. PPI was up 11.2% year-over-year and core PPI was up 9.2% year-over-year.

Source: Briefing.com 

Those aren't the Everest-like peaks seen in the 1970s and 1980. Nevertheless, the current inflation readings are at treacherous altitudes that haven't been visited in the case of CPI since the early 1980s.

We can't say for certain that we are at peak inflation, not with Russia continuing to wage its war in Ukraine and China continuing to wage its war on COVID with a zero-tolerance approach. What we can say, however, is that the market should be careful about cheering peak inflation, because cheering peak inflation is also unwittingly cheering a peak in the recovery.

The Pivot Is On

Inflation needs to come down. There is no question about it. The way it comes down and the pace at which it comes down are the unanswered questions.

To be fair, supply constraints have played a huge role in driving the outsized inflation prints, yet there are other factors on the demand side that have contributed to the worst inflation readings in 40 years.

That would be roughly $10 trillion combined of fiscal and monetary stimulus that led to huge increases in the money supply, huge upticks in personal savings, and huge increases in asset prices that were catalyzed by the artificial suppression of interest rates driven by quantitative easing.

So, here we are. The stimulus pivot is on.

Fiscal support, outside of the infrastructure bill, is fading fast. Monetary support is being pulled, but arguably not nearly fast enough. A growing number of Fed officials, though, seem to recognize that and have been paying a lot of lip service to the idea that the Fed needs to move rapidly to the neutral rate -- and beyond for some hawks -- and take a more aggressive approach in reducing the size of the balance sheet (i.e., quantitative tightening) than the Fed did during the previous recovery.

This understanding, combined with base comparison math, a strengthening dollar, predilections that supply chain problems will keep improving, and, ironically, the demand destruction that results from the high inflation, is the basis for thinking inflation readings will start to fade from their March peaks.

It would be a welcome sight if, in fact, they did, but it may just be a short-lived feeling of relief given some emergent activity in the stock market that is more consistent with an outlook for much slower economic growth.

Just Getting Started

A picture is worth a thousand words, or so it is said. Here we present a few pictures for consideration that are out of sync with a strong economic outlook.

Specifically, we're looking at the Dow Jones Transportation Average, the Philadelphia Semiconductor Index, the SPDR S&P Regional Banking ETF (KRE), and the iShares U.S. Home Construction ETF (ITB), none of which are trending of late in a manner consistent with feel-good attitudes about the economic outlook.

 

Source: Briefing.com 

You want to see the trend lines on these charts moving up. That would be construed as a sign of confidence in the economic outlook that presumably translates into stronger earnings growth. Alas, current trend lines are suggesting the opposite even though the market is presumably embracing the idea that peak inflation has been hit.

This is the case most likely because the connection is also being made that the Fed is intent now on using rate hikes and quantitative tightening to "cure" inflation. That will translate into higher market rates (and has already) that will first curtail borrowing activity and consumption on the margin before having a broader influence.

To a certain extent, things are just getting started there, evidenced in part by the nation's banks disclosing increased provisions for credit losses in their first quarter earnings reports.

What It All Means

From an objective standpoint, the March CPI and PPI reports were downright bad. There was nothing to cheer there, except maybe if you are thinking of buying a used car. Still, when things are as bad as those inflation reports suggested, the market likes to think things can't get any worse.

That could be true here, but with the war effort in Ukraine getting bogged down and the reported logistics/supply chain problems in China stemming from lockdowns to stop the spread of Covid, there's no guarantee things are going to get significantly better soon.

The Fed, however, now sees a target on the back of inflation. That's the only way it can see it because the Fed has been running behind inflation for too long. It will now be playing catch up with aggressive policy normalization efforts. As it does, the inflation rate is apt to take a step down but so will the economy.

That is the knock-on effect of rising interest rates, which are necessary to get inflation under control.

Cheering peak inflation, then, is tantamount to cheering the arrival of slower economic growth and slower earnings growth that should translate into lower earnings multiples.

To that end, peak inflation is more bad news than good news right now.

--Patrick J. O'Hare, Briefing.com

Originally published on Briefing.com.

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