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Tuesday, June 28, 2022
The Federal Reserve is working hard to bring down inflation, raising interest rates at the fastest pace in nearly 30 years.
Recently, some analysts have begun to explore the idea that inflation may moderate in the coming months.
But this decline likely won’t be due to the efforts of the Powell Fed.
It “increasingly looks like markets mistook [the] ‘bullwhip’ effect of supply chain (including food) for secular inflation,” Tom Lee, Fundstrat’s head of research, wrote in a note Sunday.
The “bullwhip effect” describes, roughly, the tendency of businesses to over- or under-estimate the amount of inventory they will need relative to consumer demand, resulting in volatility in orders across the supply chain.
In the case of the past year, retailers over-estimated, leading them to broadly over-order from wholesalers, who then in turn over-ordered from their own suppliers – leading, in aggregate, to a major mismatch between consumers’ actual demand and inventories on hand. The bloated inventory levels at Walmart (WMT), Target (TGT), Gaps (GPS) and other retailers this past earnings season served as recent examples of how this effect played out in real-time.
“I do not believe companies want to permanently carry higher inventory. It is expensive … and introduces huge balance sheet risk,” Lee said. “Thus, companies will want to trim inventories when supply visibility improves. The logical implication, for me, is prices will come down.”
This all may sound suspiciously similar to the Fed’s now-debunked argument from last year that inflation would prove “transitory.” And the data even earlier this year have disappointed economists looking for a peak, with May’s 8.6% CPI print unexpectedly taking out what many had expected would be the peak this year in March.
Already, however, prices for metals, commodities and energy – all raw materials in the supply chain – have fallen sharply from recent peaks. West Texas intermediate crude oil futures (CL=F) are on track to post their first monthly decline since November, and cotton futures (CT=F) have plummeted from a more than decade-high logged in May.
And this decline may come just in time.
As Jim Reid, Deutsche Bank’s head of credit strategy and thematic research, illustrates below, the Fed began raising interest rates with inflation significantly higher than seen during prior hiking cycle.
Over the past 70 years, the first rate hike has come, at the median, when the Consumer Price Index (CPI) reached 2.5%. The first rate hike this year, by contrast, occurred in March when CPI soared at an 8.5% annual clip.
The only rate-hiking cycle that resembles the current environment began in August 1980, when the Fed started raising interest rates with inflation running north of 12%.
“Where this cycle is so different … is that the first hike occurred very, very late in the inflation cycle,” Reid said. “My base case remains that the Fed will find it very difficult to ease policy notably given that inflation is going to be harder to dislodge.”
And although another ramp-up in the rate of inflation in June may be in the cards, this does not preclude a deceleration in inflation later this year.
“June is bound to see another big jump in the headline index, thanks to the surge in gas prices in recent weeks, but the abrupt drop in wholesale prices … means that retail gas prices are set to fall quite sharply over the next few weeks,” Ian Shepherdson, chief economist at Pantheon Macroeconomics, wrote in a note.
“At the same time, core pressures are starting to moderate, thanks mostly to slower wage growth at the margin, so we would be surprised to see the core CPI keep rising at the recent 0.6% per month pace.”
Shepherdson said he expects headline CPI to rise by 1.0% in June but then average an only 0.3% rise over the next few months thereafter. And this could then give the Fed leeway to slow its pace of tightening by the end of this year, he argued, even as it refuses to budge from its hawkish rhetoric for now.
“Policymakers know very well that the path of inflation, especially the core rate, over the remainder of this year mostly is baked-in and is impervious to their interest rate decisions. Monetary policy works with long lags,” Shepherdson said.
“But the Fed has constituencies other than monetary economists; they have to calm the inflation fears of the public, the markets, and politicians. That means they have no choice but to sound as tough as possible, because part of their job is to rein-in inflation expectations.”
Adding: “If inflation then falls faster than their base-case forecast—and the market’s—then so much the better.”
What to Watch Today
8:30 a.m. ET: Advance Goods Trade Balance, May (-$105.4 billion expected, -$105.9 billion during prior month, revised to -$106.7 billion)
8:30 a.m. ET: Wholesale Inventories, month-over-month, May preliminary (2.1% expected, 2.2% during previous month)
8:30 a.m. ET: Retail Inventories, month-over-month, May (1.6% expected, 0.7% during prior month)
9:00 a.m. ET: FHFA Housing Pricing Index, April (1.6% expected, 1.5% during prior month)
9:00 a.m. ET: S&P CoreLogic Case-Shiller 20-City Composite, month-over-month, April (1.85% expected, 2.42% during prior month)
9:00 a.m. ET: S&P CoreLogic Case-Shiller 20-City Composite, year-over-year, April (21.20% expected, 21.17% during prior month)
9:00 a.m. ET: S&P CoreLogic Case-Shiller U.S. National Home Price Index, year-over-year, April (20.55% during prior month)
10:00 a.m. ET: Conference Board Consumer Confidence, June (100 expected, 106.4 during prior month)
10:00 a.m. ET: Richmond Fed Manufacturing Index, June (-5 expected, -9 during prior month)
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