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Blame it on the Fed – Part II: Inflation

The biggest surprise of the month, a -1.4% real GDP print (preliminary) (market consensus was +1.0%) was greeted with a yawn on Thursday (April 28) because the components pushing down the GDP were not consumer spending issues.  The biggest culprit was the balance of trade (imports greater than exports) which subtracted -3.2 percentage points from the GDP calculation.  Inventories and the government sector (federal, state, and local) subtracted -0.8 and -0.5 percentage points respectively.

But, because real consumer spending rose at a +2.7% annual rate, markets ignored the negative headline.  Besides consumer spending, residential construction rose +2.4 percentage points, while non-residential was up +9.2 and capex by +15.4 percentage points.  The equity markets climbed, with the DOW up 1.9% on the day, S&P 500 by 2.5% and Nasdaq by 3.1%.  Bond yields reversed their recent downtrend, floating back toward their recent highs.

The markets are big believers that the Fed, despite its loathsome track record, is in the process of guiding the economy to a “soft-landing.”  Over the past 74 years (12 recessions), the number of times a negative GDP print has occurred without an ensuing recession can be counted on one hand (four times).  So, we remain skeptical of the Fed’s “soft-landing” skills.  The trade balance is worsening, and not by small amounts.  We don’t see an end to sky high imports, especially as the dollar strengthens.  March’s trade for goods balance was a record -$125.3 billion (the consensus was -$105 billion), up a whopping 18% in just a month (February: -$106.3 billion).  And we don’t see the government sector going on a spending binge anytime soon, especially given the horrible inflation numbers of late.  Those items will continue to be headwinds for real GDP growth. 

The question is, with all the recent consumer surveys pointing to belt-tightening as inflation eats into real income, will consumer spending continue to rise?  We think not, especially since the savings rate has now dropped below its pre-pandemic level.

The equity markets for the week showed a lot of volatility with huge positive and negative  intraday and day to day swings, conditions usually accompanying a significant “correction” or “bear market.”  The table shows the performance of the major indexes for the week and from their peaks.

 Date of PeakPeak LevelValue on 4/29/22% Chg.
S&P 5001/3/224,796.564,131.93-13.9%
Russell 200011/8/212.442.741,863.03-23.7%

Note that both Nasdaq (tech) and the Russell 2000 (small cap) are in “bear” markets (down more than 20%).  As the headline of this blog suggests, much of what is going on has to do with the Fed.  In our last blog, we described the Fed’s role in what we characterized as “The Brewing Recession.”  With the just released preliminary Q1 GDP numbers, we now wonder if the recession is just “brewing,” or if it has already arrived.  Time will tell! 

The Fed’s Role

In reaction, or should we say “over-reaction,” to the pandemic, the Fed lowered the Federal Funds rate (FF), the rate for overnight bank borrowings of reserves, to a range of 0% to 0.25%.  It expanded reserves in the banking system by 63%.  They did this by expanding their balance sheet from $4.17 trillion to $8.94 trillion between February 19, 2020, and March 23, 2022.

During this two-year period, the Treasury issued a net of $6.4 trillion of debt; the Fed absorbed about 75% of the Treasury’s total net issuance.

In addition, during that two-year period, the money supply (M2) grew by 22% while the economy grew at total of 2.7%.  Lucky for us that the velocity of money contracted, else inflation today would be much worse than it is. By purchasing most of the debt issued by the Treasury, in effect, funding the free-money gifts from the Congress, the Fed participated in and enabled today’s inflation spasm.

To reiterate how the inflation began:  the pandemic caused world governments to shut-down economic activity.  The result was a shift to the left of the supply curve. 

In the U.S., the “free money” buoyed income, thus holding the demand curve at approximately its pre-pandemic level.  The Econ 101 chart portrays the impact.  Demand remained fairly constant, but the contraction in supply, due both to business shut downs and transportation clogs, caused the initial inflation spurt.

The Fed is supposed to be independent of the political system.  It has more economists on staff (more than 400) than any other institution in the world.  They had to know the potential inflationary impacts they were unleashing. 

As we have discussed in past blogs, the Fed’s tools impact demand, especially via interest rates.  The impact of higher rates on economic activity is much more rapid than one would intuit.  That’s because people don’t buy houses or cars, they buy payments.  And those payments are a function of interest rates.  In an economy where 70% of households have little savings, higher payments have an immediate impact on purchases.  In addition, since 1990, incomes are no longer adequate to support the cost (standard) of living, and households have had to borrow to keep up.  That has expanded the leverage in the economy and is why a sharp rise in interest rates has an immediate and negative impact on consumption.

Inflation: The Base Effect

We all remember that the Fed initially labelled the emerging inflation as “transitory,” an unfortunate label.  It came with no time horizon expectations.  “Transitory” was interpreted by most as a few weeks or, at most, a few months. 

The chart shows the Y/Y percentage changes in the CPI by month beginning in 2019.  Note what happened to CPI when the pandemic first hit in April and May of 2020.  Inflation was basically non-existent, and it was muted during most of 2020 and early 2021 due to the lockdowns.  Also note that Y/Y CPI inflation really took off in April and May of 2021. 

One of the reasons that recently reported CPI has been so high comes from something called “the base effect.”  This is an impact that the denominator has when comparing Y/Y data.  Consider the simple example in the table where there is a beginning base value, a change is added to the base, giving an-end-result.

PeriodBaseChangeResultPct. Chg.
1505010050/50 = 100%
21005015050/100 = 50%

Note that in both periods there was a change of 50 units.  The base (the denominator) in the first period  is lower than the base in the second period.  While the change is the same in both periods, because the base (the denominator) in the first period is lower than in the second period, the percentage change is higher. 

Now look again at the CPI chart.  Note that the “base” for the April and May calculations of CPI will be much higher than they have been for the past 12 months (refer here to April 2020 through March 2021 data).  And now note that going forward, the base grows rapidly.  The result is that the “base effect” should temper Y/Y CPI data for the next 12 months.  This base effect means that the same absolute dollar “change” in prices in May as in March will result in a lower Y/Y inflation print.  Due to the “base effect” alone, we believe that March will prove to be at least an interim peak in inflation as measured by the CPI. 

Gas & Rent

But there is more than the base effect at work here.  Oil prices (West Texas Intermediate (WTI)) have stabilized at around $100/bbl.  They were as high as $123.70 (March 7) in the immediate aftermath of Russia’s invasion of the Ukraine.  And, while gasoline prices are still sky high, they are slightly lower than they were in March.  Energy has an 8% weight in the CPI calculation, so those lower prices will have a meaningful impact on April’s CPI reading. 

Then there are rents.  These compose 30% of the CPI calculation.  We have commented several times in our last few blogs that multi-family housing construction is at a new 50-year high.  We have noted that the apartment vacancy rate has ticked up and we expect it to move higher as finished apartments come to market.  Economist David Rosenberg has calculated that the volume of multi-family units coming to market will reduce rent inflation from its current 4.4% Y/Y rate to the 3% area by year’s end.


The weakening housing market has been a favorite topic of ours.  New (-8.6% March), Existing (-2.7%) and Pending (-1.2%) Home Sales are weakening.  Home prices are at nose-bleed levels.  The latest Case-Shiller Home Price Index (February) was up 20.2% Y/Y.  As noted above, big ticket items such as autos, homes and even appliances are purchased if the “payments” are affordable.  Rising interest rates have already impacted home sales, and the future looks weak as mortgage applications to purchase continue to tumble (-18.5% Y/Y) (see the chart at the top of this blog).  As one can tell from the monthly data, rising rates have already impacted home sales and falling mortgage purchase applications bodes ill for this market.  If the past is prescient (i.e. 2007-08), the next phase in home prices will show soft, or even negative home price growth. 

And Commodities

There has been significant upward pressure on prices from commodity inputs.  The good news is that we now see lower “expectations” for future prices.  In market parlance, this is known as “backwardation.”  As shown in the table, markets believe that the current situation is temporary, and prices in the future will be lower.

CommodityChg. in Spot YTDFutures to Spot
Natural Gas107.6%-38.5%

                        Prices as of April 22


To us, it looks like the Fed’s initial “transitory” call was correct.  They botched it by not grounding “transitory” into a specific time frame, misleading the public into thinking it meant a few months, or even weeks.  But, they now appear to be in ”panic” mode as each higher CPI number has made them look incompetent (I know what you’re thinking here – “maybe they are!”) and turns up their hawkish rhetoric.

Quantitative Tightening (QT)

QT means the shrinking of the Fed’s balance sheet.  Financial markets have become hooked on the liquidity provided by Quantitative Easing (QE).  And the Fed has just ended this buying program.  As we write, they are neither adding (QE) nor subtracting (QT).  At their March meeting, they announced their intent to shrink their holdings by $1.14 trillion/year ($95 billion/month) for the next three years.  This process will begin in May and represents quite a reversal.  Normally, one would expect a significant period-of-time when there was neither QE nor QT.  The fact that they raced to close-down QE and are going to immediately begin QT is a tacit admission of how far behind the curve they have been.

The last time the Fed began to shrink its balance sheet was in late summer, early fall of 2018.  The S&P 500 peaked in September and fell nearly 20% by Christmas, with 75% of that downdraft coming over a short three-week span in December.  This time, the balance sheet shrinkage is scheduled to be twice as fast.  We know what you’re thinking – history often rhymes. The table of the major indexes shown near the top of this blog indicates that there already is some trepidation in the markets.

The Fed’s Dilemma

With the release of the preliminary Q1 real GDP growth rate on Thursday (April 28), the Fed can say goodbye to its +2.8% GDP growth forecast for all of 2022.  This +2.8% was a step or two down from the +4% growth forecast which they held until their March meeting.  The simple math says Q2, Q3, and Q4 must average 4.2% growth for the 2.8% annual forecast to be fulfilled.  Given weakening incoming data, the odds of achieving such a result appear to be near 0% (400 economists you say!).

At the May meeting, the Fed is going to have to confront this data and they will have to lower the full year’s guidance.  Remember, they can’t forecast a recession and be tightening policy at the same time.   Realize that even if they lower their 2022 full year forecast to 1%, it means that the average growth in Q2,Q3 andQ4 will have to be 1.8%.  And that’s not something that currently appears achievable with fiscal drag, inflation, rising interest rates, and QT. 

The Fed also insists that it is “data dependent.”  If this is true, then a -1.4% Q1 real GDP growth rate won’t be something they can ignore.  And, if the unemployment rate hooks up, even slightly, to keep their credibility, they will have to become less hawkish. Lucky for them, if we are correct, the April and May CPI data will show some improvement, perhaps providing them with some breathing room.  That doesn’t mean they will stop the tightening process.  But it could mean that the speed of the process will have to slow and/or the “terminal” rate will be lower.  Since the fixed-income (bond) market has already priced in the current hawkish speed and terminal rate, some repricing there may be in order.

Robert Barone, Ph.D.

(Joshua Barone contributed to this blog)


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