Nicholas Glinsman | January 13th, 2022
· As in the early 1980s, new realities test the idea that interest rates reflect ‘rational expectations
· Fed speak – there has been a fair amount
· Let’s consider some aspects of yesterday’s CPI, which in and of itself looks durable
· Inflation watch – Cotton hits decade high after US cut its domestic crop outlook
· US Elections – 2022 Midterms Preview through the lens of history
As in the early 1980s, new realities test the idea that interest rates reflect ‘rational expectations.
The interest rate on the 10-year U.S. Treasury note hovers around 1.75% while the annual rate of inflation nears 7%, suggesting that investors believe high inflation is temporary. Evidently the market expects the Federal Reserve will soon bring inflation back to within a narrow band centered on 2% a year, despite the surge in federal deficits and the central bank’s monetization of a large fraction of those deficits.
Today’s low interest rates “forecast” low inflation, a “rational expectations” idea that now comforts the Fed. But the central bank shouldn’t feel too complacent.
The Fed confronted a similar situation in the early 1980s, but in reverse. Chairman Paul Volcker convinced his colleagues on the FOMC to raise short-term interest rates to extinguish double-digit U.S. inflation and the associated double-digit long-term interest rates. Volcker and the FOMC had promised in public that measures to tighten money and credit weren’t one-time actions but part of a permanent strategy to arrest inflation. They reasoned that once the market understood the FOMC meant business, long-term interest rates would quickly fall to reflect the prospective decline in inflation implied by the FOMC’s strategy. Unfortunately, they were in for a nasty surprise.
Long-term interest rates didn’t decline quickly. The 10-year Treasury note averaged 11.5% in 1980 and rose above that level in 1984, despite a decline in the rate of inflation from more than 12% in 1980 to less than 4% in 1984.
The failure of interest rates to reflect the new monetary reality deeply troubled Volcker and the FOMC. One member complained during internal discussions early on about long-term interest rates going “up instead of coming down.” The market seemed not to believe that the Fed would stick to its guns, and instead put its money on the view that the same forces that caused the 1970s Fed to fuel high inflation would make the Volcker-led FOMC do the same. Investors refused to believe that a new monetary regime had arrived with Volcker, betting that policy would revert back to past behavior.
Volcker’s imperfect credibility probably raised the cost of stamping out the 1970s inflation. If the market had more quickly understood Volcker’s persistence as an inflation fighter, the recessions of the early 1980s would not have been so deep. In addition, the “rational expectations’’ theory that long-term interest rates provide good forecasts of average inflation would have worked better. Instead, interest rates remained too high for too long as predictors of inflation. It was 1986 before the 10-year note rate averaged in single digits.
We worry that today’s situation is the flip side of the Volcker experience. Forty years of price stability have given breathing room to today’s Federal Reserve, but U.S. interest rates could again provide erroneous forecasts of inflation. Most market participants have apparently played down the possibility that we are in a new monetary and fiscal regime, one in which policy makers don’t worry enough about large deficits and excessive money creation and new purposes like addressing climate change distract the Fed from inflation. We hope our fears are misplaced, but if they aren’t, the new reality of higher inflation will eventually take hold, and the 10-year rate will jump to reflect that regime. History teaches that central bank credibility usually moves slowly in both directions.
Fed speak – there has been a fair amount
· Fed’s Daly, Harker Join Calls for Rate Liftoff as Early as March
Federal Reserve Bank of San Francisco President Mary Daly and her Philadelphia Fed peer Patrick Harker joined the ranks of officials publicly discussing an interest-rate increase as early as March as the central bank seeks to combat the hottest inflation in a generation. “I definitely see rate increases coming, as early as March even, because it really is clear that prices have been uncomfortably high,” Daly told PBS NewsHour in an interview last night. “American consumers are feeling the pain.”
· Patrick Harker supports at least three increases this year and is “very open to starting in March
Harker supports at least three increases this year and is “very open to starting in March,” he said in an interview with the Financial Times today. Harker is one of several Fed officials to signal support for “lift-off” in March, along with regional bank presidents Esther George of Kansas City, James Bullard of St Louis and Cleveland’s Loretta Mester. Harker warned of a “longer-term problem” if the Fed allowed price growth to hover at levels well beyond its inflation target of an average of 2 per cent over time. “Ultimately, what we worry about is that people start to think, ‘Well, inflation is just not going to be at 2 per cent, it’s going to be at 2.5 per cent or 3 per cent going forward’,” he said.
The president of the Philadelphia Fed also indicated he would support a relatively quick effort to cut the size of the US central bank’s balance sheet, which has swollen to $9tn after it hoovered up bonds during the coronavirus crisis to stave off economic collapse. Harker suggested the Fed should move more quickly than it did in the wake of the 2008-09 global financial crash, when it waited for two years after its first post-crisis rate rise before it started to shed assets. Harker said the Fed could begin the “run-off process” once interest rates were “sufficiently away” from zero, which could mean a reduction in its bond holdings as early as the end of this year.
· Lael Brainard says fighting inflation is Fed’s ‘most important task’
Lael Brainard, Joe Biden’s nominee for vice-chair of the Federal Reserve, will tell Congress that the fight against high inflation is the US central bank’s “most important task” in an embrace of the Fed’s pivot towards tighter monetary policy. “Inflation is too high, and working people around the country are concerned about how far their pay cheques will go,” said Brainard, a Fed governor, in prepared remarks released ahead of her confirmation hearing before the Senate banking committee on Thursday. “Our monetary policy is focused on getting inflation back down to 2 per cent while sustaining a recovery that includes everyone. This is our most important task,” she added.
Brainard is generally regarded as dovish on monetary policy, but her prepared testimony suggested she was on board with a more aggressive approach to fighting inflation. During her opening statement, she will also cite her international experience to highlight her determination to quash excessive price rises. “In some foreign countries, I saw up close how high inflation hurts workers and families, especially the most vulnerable,” she will say.
Let’s consider some aspects of yesterday’s CPI, which in and of itself looks durable
The Bureau of Labor Statistics started to publish an index that excluded food, fuel, shelter and used cars and trucks — yes, a very odd, ‘Arthur Burns’ mix to exclude — that captured most of the weirdest effects of the pandemic. Unfortunately, inflation from that index continues to rise, and is now at a 30-year high:
The overall number is still being reduced by the figures for shelter inflation, which are likely to rise as rent increases move into the calculation over the next year. Inflation excluding shelter (accounting for a third of the index) exceeds 8%. Shelter inflation is at its highest in 14 years, and has now topped 4%. The likelihood is that these numbers will converge, but housing looks likely to be a big headwind for any hopes that headline price rises will drop in short order:
Indeed, as you can see below from the Apartment List Rent Tracker, the BLS numbers have a lot of catching up to do – in fact, if you had included the 17.8% number below, then CPI would have come in with a 10-handle:
Statistically, another way to deal with a few extreme outliers is to exclude them altogether. The Cleveland Fed publishes measures for inflation of the median component index, and for the trimmed mean, which involves removing the biggest outliers on either side and taking the mean of the rest. Both measures stayed low in the early months of last year, and both are now at a three-decade high:
Meanwhile, the New York Fed has a measure of “underlying” inflation, based on the cross-correlations between inflation components, and also a broader measure that adds in a range of other macro variables. The two series can vary, but at present they are closely bunched and show the highest underlying inflation since inception in 1995:
The Atlanta Fed, on the other hand, divides inflation components into those that are sticky — where changing the price is difficult and takes time — and those that are flexible. The concern for the Fed would be to see “sticky” prices take off as they, by definition, will be difficult to move back down again. And indeed, sticky prices rose their most in 30 years, with December seeing the sharpest increase:
The broadening of inflation can also be seen in this chart of diffusion indexes. The share of CPI components whose prices are going down is minimal. Meanwhile, more than 80% of components have inflation above their five-year average. This time last year, fewer than 40% had inflation this high. The price shock that first hit a few specific sectors last year has, as feared, now broadened to cover much of the economy:
All in all, the above is the rationale for the Fed to have dropped the term ‘transitory’. However, can we trust this Fed to fight the inflation fight? I am not so sure, but time will tell. March could be a tough month to hike, should there be no CR to deal with the fiscal cliff, which in theory hits us on February 18th, but obviously can run well into March.
Inflation watch – Cotton hits decade high after US cut its domestic crop outlook
Cotton futures jumped to the highest in more than 10 years after the US government cut its outlook for domestic production more than analysts expected. The Department of Agriculture on Wednesday trimmed its estimate for U.S. output to 17.62 million bales, mostly because of yield revisions for Texas, the top-producing state. That compares with 18.28 million bales the USDA estimated in December, and 18.24 million consensus estimate. The agency noted shipping disruptions affecting world trade.
The fiber surged 44% last year on projections for a second global deficit. Still, cotton is rising not because of shortages, but because the fiber is not reaching the places where it’s needed.
Global consumption forecast was virtually unchanged with a 500,000-bale decline in China’s cotton use offset by gains for India, Mexico, and Pakistan. Global ending stocks were cut 726,000 bales, each weighing 480 pounds, or 218 kilograms.
Meanwhile, in the metals market, the LME specifically, copper is back above $10,000 a ton. Be careful this time as people are not talking enough about the supply side issues. From oil to metals, the world has not invested enough in the short, mid or long term supplies of most commodities, especially those needed for the push to a “Green future”, which is being imposed by the well-meaning polity and their bureaucrats, without any transition plan.
The rush is on, and there simply is not enough supply, so prices have a lot of upside – in fact multiples of the current price levels. The commodity complex could be the next trade of a lifetime, akin to Soros breaking the Bank of England, or the mortgage-backed crisis in the US, if you were short like John Paulson, Kyle Bass and Michael Burry.
US Elections – 2022 Midterms Preview through the lens of history
In our view, the consensus currently is understating the number of competitive seats, particularly in the House, that are likely to emerge closer to Election Day. Furthermore, the larger the number of competitive races, the better the prospects for Republicans. We see competitive races as more likely than not to favour Republican candidates over Democratic candidates based on our analysis of the variables we think are most likely to impact voter turnout this year.
The variables that favour Republican midterm performance are, in order of importance:
1) Democrats’ ownership of higher inflation in the US economy and the ongoing pandemic;
2) Democrats’ failure to deliver on myriad campaign promises including the Build Back Better bill;
3) a rising likelihood of progressives winning Democratic primary elections;
4) former President Trump’s involvement in Republican races; and
5) Congressional seat redistricting.
Conversely, some variables do favour Democrats, in order of importance:
1) Degradation of abortion access by US federal courts and states;
2) Trump’s involvement in Republican races;
3) Continued actions by the Biden administration and Congress to demonstrate “toughness” on China;
4) Early implementation by the administration of the infrastructure law; and
5) Congressional seat redistricting, albeit to a much lesser extent than the GOP.
From an historical perspective, unequivocally we know that lawmakers of the President’s political party are likely to net lose seats in the House. Since 1954, there has been only one occasion, 2002, when the President’s party gained seats in the House during the midterm of a President’s first term.
The Senate is slightly more of a coin-flip. Since 1954, of the 12 total first-term Presidents who have served, just under half (five total) have seen a net gain of +1 to +3 seats in the Senate for the President’s party, while the other seven first-term Presidents have seen losses of -1 to -8 Senate seats during the midterm Elections (see Figures 1 and 2 for full details).
Source: Observatory Group analysis
*Note: these midterm Elections were held just one year after the Sept 11 terrorist attacks when President Bush’s popularity was unusually high, and as such this instance is likely an anomaly
*President Nixon resigned in August 1974, just three months prior to this election which otherwise would have been a midterm held during Nixon’s second term, and thus represents a unique case.
**The 2002 midterms were held just one year after the Sept 11 terrorist attacks when President Bush’s popularity was unusually high, and as such this instance is also an anomaly
Source: University of California Santa Barbara American Presidency Project
So, history gives Republicans a material upper hand. And the current Congressional makeup only adds to Republicans’ advantage heading into November. In the House, Republicans must gain a net of only six seats to take the majority. The current very slim Democratic majority in the House means that even if Republicans gain fewer seats than typical for the opposition party in a mid-term, they are still heavily favoured to win enough to retake control of that chamber.
In the Senate, Republicans must win a net of only one seat. (All 435 House seats are up for re-election every two years. Only about one-third of Senate seats are up every two years.)
Current Congressional Party Breakdown – Republicans Must Net-Win Six Seats in the House and Net-Win One Seat in the Senate to Take the Majorities
Sources: House of Representatives Press Gallery, US Senate
More on this subject will be forthcoming, but we wanted to get some perspective and history out to you. As you are no doubt aware, we currently believe that Republicans will take both the House, with a relatively large margin, and also the Senate,