Inflation, Inflation, Inflation! What It Means for the Fed

Last Edited by: LPL Research

Last Updated: September 13, 2022

Inflation, Inflation, Inflation | What It Means for the Fed

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Podcast Intro:

From LPL Financial, welcome to Market Signals.

Lawrence Gillum:

Hello and welcome to another edition of LPL Market Signals. My name is Lawrence Gillum, Fixed Income Strategist here on the LPL Research team, and I'm your host today, and I can't think of a better person to join me today than our Chief Economist, Dr. Jeffrey Roach. So, we're recording this podcast on September 13, and after today's higher than expected inflation report, we're lucky to have Jeff here to talk through and dig deeper into today's inflation report. So, with that, Jeff, how are you doing today? I know you're extremely busy, so thanks for taking the time.

Dr. Jeffrey Roach:

Yeah, you're welcome, Lawrence. And it is a nice morning. I wouldn't say it's a good morning to you because of the frustratingly high August inflation report we got. We can talk more about that, but yeah, it's been it's been crazy this morning.

Lawrence Gillum:

Yeah, and that's really all we're going to talk about today is inflation, inflation, inflation. Today's CPI report was much higher than a lot of folks expected. Markets obviously did not react positively to the higher-than-expected inflation report. So, we're going to dig into the inflation report a little bit more deeply as we go through this podcast. And then importantly, talk about what the Fed is going to do after today's report. Kind of how is that, how has their reaction function changed? And then, you know, with the $64,000 question, is a softish landing still a realistic possibility given what the Fed is likely to do and given the higher-than-expected inflation report. So, with that, why don't we just go ahead and jump right in. So, Jeff, we did see higher than expected inflation reports today. The both the headline and the core were above analyst expectations. Kind of what was your first impression of today's reports?

Dr. Jeffrey Roach:

Yeah, so Lawrence, just this is for those special listeners and watchers of our podcast. They know now what we do behind the scenes. So, you know, typically on a early exciting morning like this also on those Friday job reports mornings, you know, you get up, you get your spreadsheets ready, you get your coffee ready, you get Bloomberg's ready. Also always go, this is me just personally, I always go to the government websites making sure that we're getting all the information as clearly and quickly as possible. Well, and the first thing that hit me when I was, when I was reading the report, right on the BLS website this morning was you know, really kind of the confusing, a little bit confusing report in the sense that, you know, you had airfare down, you had used car prices down, you had some components, you know, off, off their highs.


But on the other side, you had meat prices, chicken, fish, you know, dairy also of course, rents, which is very, very important to track. You know, you had some furniture, some of those components. So, you know, you had the headline numbers we're showing right here in the graph headline is clearly past peak, you know, the dark blue line. But, you know, when you drill into the details, what struck me? And, and just, just to be honest with you, I'm going to actually talk a little bit more in depth on this in the Econ Market Minute podcast. But what strikes me is the fact that this post-COVID environment particularly hurts the lower income families in this country. Food prices, rent prices up, clearly hits lower income more. That was kind of the first takeaway that I had as I'm reading this report, what is it? What does it mean? How's it going to feel? And that's, that's why that's my first of many takeaways.

Lawrence Gillum:

Yeah, unfortunately, there isn't a lot that the Fed can do to arrest those higher food prices, those higher rent prices for the most part. And we're going to talk about kind of the Fed's reaction function in just a second. But we did see if there is a slight glimmer of hope. We did see that the broadest measures of inflation have started to kind of roll over. So not as many price increases compared to last month. Again, just a small glimmer of hope, but these inflationary pressures are still very broad based and still hitting a lot of the different categories. So, the Fed is really kind of stuck in this hiking cycle until a lot of this inflation data rolls over.

Dr. Jeffrey Roach:

Yeah, it is a services led type of problem right now, though. So, you know, I think generally speaking, it's those durable goods. They're still off peak that, and that's fair to say, but it is services, so it's medical services, it's even some of the recreational prices. But food is what makes me nervous. The other thing that I got out of the report, I didn't mention this earlier, was, you know, electricity prices, natural gas prices. You know, clearly the decline in gas prices at the pump could be in the near term, you know, on the positive side for consumer confidence. But electricity prices, that's definitely going to show up as we go into the winter months.

Lawrence Gillum:

All right, so markets obviously did not react well to the report today coming in right before the report, we had yields lower, equity futures higher, a minute after the report posted, yields gap higher equity prices really were, were down quite significantly. And at the time of this recording and are still down pretty significantly. You know, what's interesting is last week we had eight Fed officials, six voting members. We had the ECB raise rates by 75 basis points. And Bank of Canada raised interest rates by 75 basis points. But equities and risk assets rallied, that's certainly not the case today. So, you know, we talked about maybe peak hawkishness last week. It doesn't look like we're there given this report now. So maybe we can skip ahead and talk a little bit more about what we're seeing on the inflation front, but then importantly get into what the Fed's reaction function's going to be after today.

Dr. Jeffrey Roach:

So piggybacking on what you just said, Lawrence, about Fed reaction function, I think what got markets skittish this morning is that, you know, if we thought that, you know, inflation could come down in August a little more than what we saw in this headline number, you know, that the market, it can expect the Fed to move past all of its front loading. I think after a report like this morning that it pretty much cements in the 75 basis point hike that's going to happen in the next meeting upcoming. And so, you know, that's, I think that's probably the frustration right now. The market's saying, okay, we know about the front loading. We know that the Fed's going to be you know, trying to keep their inflation fighting hats on, and they're committed to that, but eventually downshifting to 50 and 25 basis point hikes.


At this point, they're still going to be keeping with that 75 basis point hike. So, looking at this graph, you know, this basically just says, well, what parts of inflation are demand driven and what parts are supply driven? The Fed can't do anything about the supply driven components, only the demand driven components. The blue portion is the supply driven component. And so, a little bit hamstrung and a little bit frustrating because you'd think, and we've talked about this, you know, it's nothing new here. We're talking about, hey, once supply chains improve, bottlenecks kind of clear up, we expect inflation to start easing. We've been saying that, and unfortunately, when you read this August CPI report, it says, if improved supply chains haven't really mattered quite yet, and if you wanted to take the more positive spin out of that, you might say, well give it some time and it'll take a little bit of a lag time between improved supply chains and actual easing consumer prices. But at this point, we're not quite there yet in seeing the fact, the positive impact of improved supply chains on the inflation metrics.

Lawrence Gillum:

Yeah, and to your point, we have seen those supply chain metrics improve. The Fed posts their metrics. I think it's the first couple days of the month. But you know, we have seen some of those metrics improve. But yeah, to your point, it just hasn't shown up in the data just yet. So, you know we do think that the Fed is, again, to your point, is going to continue to hike rates despite the fact that their rate hikes can only really impact half the inflation rates that we're seeing currently. So, as it relates to central banks we're seeing a pretty aggressive monetary response globally given the high inflation pressures that we're seeing across the world. There's 40 central banks now that have increased interest rates by 75 basis points, again, including the ECB last week and the Bank of Canada again last week. And it sounds like the Fed is on track for another 75 basis point rate hike next week. But you know, the fact that all these central banks are tightening at the same time, kind of what's our outlook for the impact that this is going to have on economic growth.

Dr. Jeffrey Roach:

Yeah, that's a great question. And Lawrence, by the way, just a quick shout out to one of your blog posts from last week where you highlighted some of the ECB action. I thought that was a great blog post. If advisors haven't seen that yet click on our LPL Research website and see last week's ECB note as well as the most recent blogs for the CPI report this morning. So, you know, one of the things that I'll say is that it's good to see coordinated activity among central banks. So, you know, you typically will see a lot more volatility in FX markets, even in just general flows of capital across borders when you have, you know, half the world tightening and half the world loosening.


So, in some ways, a coordinated effort is a good thing you could say. Yeah, and in this case, you know, by far, you know, we're seeing fairly coordinated activities across major countries. However, point of this graph is saying, you know, China and Japan are the outliers right now, but in some ways it's helpful. This is a global inflationary problem. You know, it was a global pandemic. There was global shutdowns, global reopening. So, in many ways, the fact that they're coordinating is a good thing. But overall, I would say in some ways you could say the U.S. central bank is more consistent and more aggressive in its hiking. You know, they were the first ones to start front loading, clearly not offsetting their tightening decisions by providing you know, stimulus like the ECB. It's almost as if you got one hand on the other hand, right?


The ECB is saying, let's hike rates, but also provide stimulus for countries like Italy. The U.S. is quite hawkish and quite aggressive. But I think they can handle that because I think our U.S. economy is relatively better off than some of the others. One of the things I've blogged about, just briefly in one little passing comment, Lawrence, to your point about, you know, how this inflation report was received. You know, when you think about higher electricity bills in this country, and you think about the fact that the year on year growth rates now are as high as they were since 1981, food prices highest since the 70s on a year of year growth rate. But it's really important to remember, you know, we do not have an energy crisis like Europe does. And so hence the U.S. central bank can kind of get away with some of their hawkishness at this point.

Lawrence Gillum:

Yeah, the ECB is in a difficult situation though given the energy crisis that they're experiencing over there and just the fact that they have all these, not all these, but the peripheral parts of Europe are still highly indebted. And you know, last time the ECB embarked on an aggressive rate hiking campaign, we had the European debt crisis. So, they are much more challenged than we are here. You know, 75 basis points, it's more than likely going to take place next week. The terminal fed funds rate, though, after today's report, has increased, you know, markets are expecting a terminal rate of about 4.25% up from, you know, just under 4% following or right before this CPR report. So, you know, I think that's something important as well to talk about, just given the fact that if this does come to fruition, nearly 400 basis points of increases in one year are going to certainly impact the economy here in the U.S. And remind listeners what's the lag for rate hikes and impacting the U.S. economy?

Dr. Jeffrey Roach:

Yeah, on average, you kind of think of like a 12-month lag. You know, it takes some time for things to kind of filter through, you know, the increasing rates, it quickly shows up in borrowing costs, right? Look at where mortgage rates are right now. So, on average, the national average for the 30-year fixed rate mortgage is over 6% right now. So that's going to filter through and start slowing down even more dramatically the slowdown we've already seen in housing. And so, you know, I think at this point, the implications, Lawrence, of what you just said about, you know, terminal rate above 4%, I think it really starts, you know, changing forecast for 2024. You know, I think you think about it, you know, we had released our Mid-year Outlook about turbulence, et cetera. You know, and you know, the markets never sleep, so it's time to start thinking about, you know, 2023 and at this point, 2024 is going to be more and more important, especially as inflation continues to kind of stick around a lot longer than anybody had originally planned.

Lawrence Gillum:

Yeah. And along with rate hikes, oh, by the way, we also have quantitative tightening going on in the background where the Fed is not as active in bond markets. You know, we saw that fairly evident yesterday, the Treasury Department had a three year and a 10-year auction yesterday, and it wasn't very well received. So, without the Fed participating in these markets, we do expect a lot more volatility in the bond market certainly, but also on the equity side and it sounds like on the economic front as well. So, I think that the main takeaway for investors is that, you know, expect a lot more volatility in the, you know, months and year ahead given, you know, the withdrawal of liquidity. We don't think it's going to be to the point where it's going to be overly disruptive but we do think that there is going to be increased volatility over the next 12 months. Yeah.

Dr. Jeffrey Roach:

One, you know, just one extra point here, Lawrence, is that you know, that this morning we got a good read on small businesses, interesting that the most recent read, there's a massive uptick in firms being nervous about finding qualified workers, and at the same time less worried about inflation. So I think that's kind of an interesting read to say, you know, from an investment standpoint, as you think about what this means for, you know, the markets and how we can, you know, allocate capital, it seems as if, you know, as we, if we can keep productivity rates high enough in this country relative to, you know, the major trading partners, there's still going to be a slight bias toward U.S. assets being relatively more attractive than European or even you know, Asian, Latin American, et cetera. Some of those emerging markets

Lawrence Gillum:

For sure. And one last comment before we put a bow on this and move into the Phillips curve of all things, we'll, you know, it is important that we pointed out with small business optimism ticking higher, and we haven't I mean, we haven't seen inflation expectations anchored yet either. So, either market implied inflation expectations or survey data coming in all these metrics point to inflation coming down. We just haven't seen it in the data yet. The data is backward looking, but all the survey data that we're seeing is, you know, somewhat positive in terms of expectations of falling inflation rates. So hopefully that does come to fruition. Yep. Yep.

Dr. Jeffrey Roach:

Well, well, you think about even like the ISM numbers. So, these are real boots on the ground people that are in charge of purchasing you know, for numbers of global firms. So, these people know what's happening. And so, when they talk about prices paid for inputs and raw materials going down, that's believable. It's not a funny number. So, the prices paid components clearly down some of the, as I mentioned, the small businesses a little less concerned on inflation relative to where they were just a couple months ago. And so, you know, at this point, let's watch that September 30, PCE deflator number. That's the more comprehensive inflation metric that we'll get for the month of August that, that gets released, September 30, a little bit after the Fed's next interest rate meeting decision.


So anyway, yeah. So, Phillips curve, you teed me up nicely there, Lawrence. This is basically just saying, you know, let's explain, or, you know, illustrate graphically the relationship between a tight labor market and inflation. The wage price spiral that everyone's talking about right now, is that going to be a major factor on keeping inflation elevated? And the flip side is, do we have to experience pain in the marketplace, (i. e., higher unemployment) in order to get inflation down? And the answer is, it's a little messy. It's not that clear. So, you, think about where we are in a post-COVID world, high inflation, low unemployment, it does not fit well for the traditional Phillips curve relationship. And it's possible that that relationship has reset to a whole new regime. And I think that's really important for us to, especially these investors when they read and hear Fed speakers talk about pain and you know, slow economic growth in order to really get a handle on inflation, what are the risks there? It's possible that we will not see a massive uptick in unemployment as much as kind of that old fashioned Phillips curve might suggest.

Lawrence Gillum:

Yeah, good stuff. You talk about this in your Weekly Market Commentary, and I certainly wanted to bring it up cause I thought it was a great point. But I will say though, that now that we've talked about the Phillips curve in this podcast, I don't think they're ever going to let you and I do this alone again. I think this was you know, too boring of a topic. But anyway let's talk about what to expect ahead. Obviously today, we're recording this on Tuesday, September 13. It was CPI day, but there are additional economic data points this week that are important to look out for as well.

Dr. Jeffrey Roach:

Yeah. So, Thursdays is probably the big one for the markets. I think trying to ascertain how steady the economy is given, you know, given these headwinds, you know, retail sales comes out, claims come out, you know, at this point, consumers are still spending you know, they're using tapping into credit, which is a little bit, you know, disconcerting, using some of the you know, other ways of you know, spending in addition to just, you know, what they get from their paychecks. And I think that's probably the biggest thing where we want to track going into Q4 and going into next year. We think Q3 is going to grow positive. We'll be over 1% most likely quarter on quarter annualized for the third quarter. Fourth quarter might not be quite as as aggressive, but it's 2023,


what are those recession risks? At this point, you know, it's a coin toss. Little bit higher risk, depending on how aggressive the Fed continues to act. Even after their September meeting, they meet again in November, December. So, we have three more meetings for the rest of this year. And you know, at this point, the economy seems to be holding, but we could have a pretty nasty surprise in the retail sales numbers in August. And so, if that happens, I think that'll add a little bit more volatility at this point. But industrial production, we don't talk about this a ton, but I like looking at that, especially as it relates to autos, auto manufacturing, inventories on auto dealers are still very low. That's why we had a nasty surprise in new car prices in this latest this morning CPI report. And if we can get an uptick in production from auto manufacturers, get a little bit better handle on inventories, we could possibly see some moderation even in the new car space. But that's not going to happen anytime soon.

Lawrence Gillum:

All right. Good stuff, as usual. So, with that, we'll wrap it up. Thanks Jeff, for joining. Obviously great insights on a very busy day for you as the inflation report came out today. Thanks, Neal, for making this ready for consumer consumption. And everyone else, thanks for listening. You know, we'll be back here again next week, same time, same place. Until then thanks for listening and I hope everyone has a great week.

Podcast Outro:

This material was provided by LPL Financial is for general information only, and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risk, including possible loss of principle. Any economic forecasts set forth in the podcast may not develop as predicted and are subject to change. References to markets, asset classes and sectors are generally regarding the corresponding market index. All indexes are unmanaged and cannot be invested into directly. Index performance is not indicative of the performance of any investment. All performance reference is historical and is no guarantee of future results. All information referenced in the podcast is believed to be from reliable sources. However, we make no representation as to its completeness or accuracy. Securities and advisory services offered through LPL Financial, a registered investment advisor and broker dealer member FINRA and SIPC insurance products are offered through LPL or its licensed affiliates.


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Inflation, Inflation, Inflation

In the latest LPL Market Signals podcast, Fixed Income Strategist Lawrence Gillum and Chief Economist Dr. Jeffrey Roach discuss what the higher than expected August CPI report means for the Fed, the markets, and if a soft landing is still in the cards.

CPI report surprised to the upside

The August Consumer Price Index (CPI) rose 8.3% year-over-year (YoY) from 8.5% in July. Excluding food and energy, the core CPI rose 6.3% (YoY), accelerating from last month. Both headline and core inflation were higher than analyst expectations. Inflation pressures continue to ease in a few categories such as gasoline, airfare, and used vehicles. However, several categories are still running hot. Food prices rose 11.4% from a year ago, the largest year-over-year increase since 1979, and electricity prices increased 1.5% month-over-month, the fourth consecutive monthly increase. However, as import prices and producer prices ease, the inflation outlook should improve.

How Does the Fed’s Reaction Function Change with Today’s Report? Is a Soft Landing Still Possible?

Headline inflation is likely past its peak, but the Federal Reserve (Fed) still has work to do. The Fed will likely increase rates again by 75 basis points later this month as core inflation is not cooling as fast as expected. The Fed has two more meetings after next week’s meeting, and we’ll likely continue to see interest rate hikes at those meetings as well. The real risk to the economy is in 2023 when higher interest rates will likely flow into the real economy. At this point, we think there is a 50/50 chance of a recession in 2023.

What Does the Inflation Report Mean for Stock and Bond Markets?

Right after the CPI print was released, equity markets were sharply lower and bond yields sharply higher. With the Fed likely having to hike interest rates more than markets were originally expecting, that has put upward pressure on short-term yields. And with the prospects of higher rates, equity markets sold off broadly with all sectors down after the report.

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This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth in the podcast may not develop as predicted and are subject to change.

References to markets, asset classes, and sectors are generally regarding the corresponding market index. All indexes are unmanaged and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

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