🔔 Doubling Down On 'Transitory'

Yeah, the Fed did it again and doubled down on 'transitory' with their dovish taper, but let's go all narcissist & focus on what WE said earlier in the year... 👇

The focus there is on the secular forces that we believe will keep a lid on inflation going forward.

Might have to drop the narcissism already though. This is far from a victory lap.

When we wrote about this earlier in the year, we expected inflation to peak in the summer.

Clearly, it's been stickier than we, and many others expected.

One of those others is Spectra's Brent Donnelly.

I'm going to single Brent out for a few reasons:

1. He's been around the block and I know he can take 'criticism'

2. The way he thinks/presents arguments makes me think

3. He threw in the towel on Team Transitory yesterday

4. I think he's stopped himself out at the runaway inflation highs

5. His books are excellent and should be required reading for every trader

Right, back to the roast. 😆

Brent presents the idea that the five flags to disprove transitory inflation from Powell's August 27th Jackson Hole speech had been achieved and surpassed.

The backdrop:

What are those factors?

1. The absence so far of broad-based inflation pressures

2. Moderating inflation in higher-inflation items

3. Wages

4. Longer-term inflation expectations

5. The prevalence of global disinflationary forces over the past quarter century

Point by point, Brent takes Powell's arguments to task...

Let's go through them and play devil's advocate...

No doubting what this datapoint shows. An increase in core/mean/trimmed inflation.

The core measures are designed to exclude more volatile aspects such as food and energy, and the trim/mean is there to exclude other one-offs/outliers that distort the overall inflation picture.

Even with all of this tailoring, it's clearly way above target...

But I still have some questions...

• What does broad-based mean precisely?

• What if ALL of the items are behaving like food and energy?

"Please save your excellent questions until the end of the presentation"

Sorry!

Next up...

No questions on this one, I just don't think it's a good measure in the circumstances.

The methodology of the index is weighted based on a 24-month rolling average of past sales by market class. I can't find the actual weighting method so I think caution is the way to go...

The index also contrasts with the actual CPI data that show used car prices deflating slightly over the past couple of months...

Next...

JP: “Today we see little evidence of wage increases that might threaten excessive inflation” He cites the Atlanta Fed Wage Growth Tracker.

Agreed, but if these wage increases aren't keeping pace with inflation, are they even real?

Nothing to add to this, Fed are focused on long-term, where consumers are influenced by short term...

Back to Brent:

Right, hopefully you've got a good idea of what Brent's saying.

These are all excellent points....

Something I mentioned to David yesterday is how I'm treating data points right now:

Now, that doesn't mean the story's right and the data's not, I'm just looking for more context.

After critiquing Brent's take it's only fair that I put my own balls on the line too, so here's how I think this plays out, starting with this question.

What are broad-based inflation pressures?

To me, this is when everything is broadly increasing in price at the same time.

Right now, we're not quite seeing that.

We see some things going up in price, then those things stop and something else takes over.

Some of the biggest drivers of this have come from clearly constrained markets such as used cars (where the CPI data suggests that the Manheim Index is overexaggerating).

While we're on the subject of cars, it looks as if the chip shortage is going to gradually improve from here. This seems to be consensus across auto firms 👇

Increased production of new cars should mean used car prices come down and some balance returns to the vehicles market.

Most importantly, prices will find a more natural equlibirium (instead of the current supply-constrained dynamic).

This won't be fixed overnight of course, but when we're talking inflation it's rate of change rather than price levels that matter.

More cars available = higher probability that price growth slows...

Cost of Shelter is another one to watch... 👇

Will that pace of change be maintained? I'd say not...

Wages... Well, I laid out my thinking on the great resignation here 👇

Basically, I think the shift in labour power was temporary.

The government stepped in with fiscal support across all levels. The net result was that people were paid for staying at home and in many cases their savings increased.

Work became optional for a brief window of time, and if the old boss came calling with their long hours and crappy pay deal, workers had the chance to say "f**k you, pay me" for the first time in a lot of years. Many have changed jobs for better conditions & pay...

Now that support has been removed and it's either get back to work or draw on those savings...

Will that 'f**k you, pay me' optionality remain?

People are returning to the labour force now and some of those pay rises may have been overdue...

Will workers get another big rise next year?

There was a window of opportunity, but I don't think the capital/labour power has permanently shifted...

In real terms, aggregate wages haven't increased. Inflation has eaten those gains.

Unless that balance has permanently changed, consumers are getting poorer (in real terms) which will dampen aggregate demand (and inflation)...

The supply chain will take a while to be fixed, but things can only get better...

How about shipping costs?

And last but not least...

Summing up, I can't make the case for the current pace of inflation to continue.

At the risk of over-simplifying, how much more stuff can people buy?

And what if the bullwhip effect kicks in for some items...?

The shift from services to goods should be disinflationary, and see the pace of overall inflation slow.

Paradoxical as this sounds, what I'm interested in now is: how fast does it slow?

I'm pretty confident it won't keep going up at the current rates, but that doesn't mean it won't continue at a higher than acceptable rate for central bankers.

Back to Brent...

I've always taken 'transitory' at face value. i.e. 'not permanent'.

I don't think it will be permanent, but it's certainly lasting longer than expected!

That said, the policy balls are rolling and it's now a race between employment and inflation.

On that note, the Fed decision yesterday was perceived as a dovish taper.

Powell spoke about staying humble in the face of this unprecedented economy.

The old models are out of the window and they're basically winging it and hoping.

Can't say I'd do any different...

What does this mean for hikes?  

As long as inflation heads lower from here and workers return to the labour force, the transitory narrative is still intact, tapering likely continues uninterrupted at the current pace until June, then we'll see.

Barring any major shocks (looking at you China), there's no reason to think employment won't continue to recover at a decent pace.

If inflation remains stickier at these levels, and employment doesn't really pick up, then the narrative will likely switch to inflation is harming job creation and the Fed will then be forced to hike.

If employment isn't improving and inflation is too high, there's nowhere to hide.  

The relentless drop in continuing claims since mid-September suggests a strong NFP to kick things off tomorrow.

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