The Fed has two options on inflation—and neither of them are pretty

The two possible scenarios for inflation

The longer market participants view the big numbers arriving month after month, the more they’ll lose faith that the Fed’s committed to doing what’s necessary to conquer inflation. The Fed could quell the outbreak now by raising rates and otherwise modestly tightening its monetary grip, notes William Luther, an economics professor at Florida Atlantic University. But the central bank isn’t moving. Although Fed-watchers expect the central bank to hike rates twice next year, those actions would simply mark the close of its super-stimulative stance, maintained to counter the pandemic. So far, the Fed’s shown no intention of taking tough measures to slow jack rabbit prices. “Instead, all companies and consumers are witnessing is rising inflation when the CPI reports each month, and the Fed saying nothing about fighting it,” says Luther. “If prices keep increasing at the current clip, producers will start baking expectations of higher inflation into their wage and procurement contracts.” Those locked-in escalators will give the hot streak legs.

If strong inflation takes hold, Luther predicts, the Fed will face two options, both bad for the economy and stocks. “The first is that the Fed ‘sticks to its guns’ by pledging to wrestle the price trend back to 2%, and because it’s waited so long, must radically contract credit to get there,” say Luther. That course would cause a deep recession, pounding bonds and equities. In the second course, the Fed would simply accept and perpetuate the today’s higher inflation as a new normal. “The market participants would be expecting 3% inflation, and the Fed would meet those expectations by delivering 3% inflation,” says Luther. The appeal of taking that path: It would avoid an immediate recession. “The first ‘stick to your guns’ solution would be require such a steep downturn because the Fed delayed getting tough for so long,” says Luther. “It might take the second option because the harder something is to do, the the less likely the Fed is to do it.” Punting carries a cost. The central bank would be scrapping its longstanding, 2% goal, and adopting a new stance of tolerating high inflation to sidestep a recession. “That would greatly increase uncertainty for consumers, producers and investors,” says Luther. “They’d worry that the Fed is no longer credible, that it could let inflation get out of control.”

The markets are predicting high inflation for the next few years that will eventually glide to normal

For September, the Federal Reserve’s preferred measure, the Personal Consumption Expenditure Price Index (PCEPI) published by the U.S. Department of Commerce, posted a 4.4% year-over-year jump, by far the largest increase in over a decade. But as Luther points out, the pandemic hammered prices last year, so that number represents an artificially high leap from a depressed base. It’s more accurate to take a pre-COVID starting point. For Luther, a good gauge of current inflation is the annualized increase since January of 2020; that PCEPI number is much lower at 2.98%––we’ll call it 3.0%. But 3% still exceeds the Fed’s 2% target by half or a full point. “A reading of 3% right now is consistent with two possible outcomes,” says Luther. “The first is that the Fed is correct, that Inflation is hovering above its goal because of short-term supply chain disruptions.” The second is that huge government stimulus and fast-waxing wages have lifted inflation to a new, higher trajectory. In that dynamic, it will stay on that 3%-or-higher curve unless the Fed takes strong action.

Of course, if the rampage is all about ephemeral shortages and inflation’s due for a snapback to 2%, that’s a sunny scenario for stocks, bonds and the economy. But if sustained pressures are building, market participants want to know what the route the Fed will take. In effect, the Fed isn’t saying. “The Fed committed to a 2% average target in August of 2020, and reaffirmed it in January of this year,” says Luther. “But it hasn’t given a time frame for getting there. We don’t know if the target is 2% over one year, five years, ten years or longer.” Fed-watchers are even debating whether the 2% goal represents an average for an entire period, or if the Fed will tolerate higher inflation part of the time––for example, in extraordinary periods like the present––so long as the trajectory returns to 2% later in the cycle. “The Fed hasn’t given a timeline on how long it will allow inflation to go above target, and how long it will take to bring it back to 2%,” declares Luther.

What’s remarkable is that the markets still believe in the waffling Fed––at least so far. The best measure for where investors foresee inflation is the 5 and 10-year Treasury breakeven indexes. They track the yield on Treasury Inflation Protected bonds. The returns on TIPs rise and fall with the price level, sustaining the buying power of each dollar invested. As of October 29, the 5-year breakeven yield was 2.9%, near the current PCEPI inflation rate of 3.0%, and the 10-year breakeven sat at 2.5%. It’s important, however, to adjust those numbers because TIPs and the breakeven follow the Consumer Price Index, not the PCEPI that’s the Fed’s benchmark. A rule of thumb, says Luther, is that the CPI typically exceeds the PCEPI by 20 basis points. So in the Fed’s view, the market’s expecting prices to rise 2.7% through late 2026, and 2.3% over the full decade.

The five year forecast is well above the Fed’s 2% ideal. But since folks and funds are putting their money on inflation of 2.3% over ten years, prices would need to advance far more slowly in years six through ten. Averaging 2.3% for the entire span means that, to offset the rapid rate in the early years, prices must advance only around 1.9% from 2026 to 2031. What are the breakeven numbers telling us? Put simply, investors believe inflation will remain well above what they’re used to for the next several years, but will then trend downwards towards the slow march of the past two decades. One possible explanation: They buy the Fed’s stance that when the channels from plants to stores and warehouses get unclogged, prices will return to their old trajectory.

The other possible rationale is that if inflation keeps flaring when the shortages ease, the Fed will take action. If huge federal spending or other stubborn forces push upwards, the Fed will push the downwards on its side of the scale, as hard as it takes to get the pace back to 2%.

The Fed’s “expectations trap”

All we know for sure is that right now, high inflation’s sticking month after month. That’s raising doubts that supply constraints are the whole problem. For Luther, the big question is whether the Fed is really so committed to the 2% goal that if it will yank the throttle if prices keeps racing. “My fear is that the Fed has set an expectations trap,” he says. “It’s leaving market participants guessing. We’re already seeing their worries reflected in higher bond yields.” Luther says that if the Fed wanted to reassure consumers and producers of its dedication to the 2% rule, it would establish intermediate guideposts that showed how much of the price increases were coming from today’s delivery roadblocks, and how much from longer-lasting shifts, such as heavy spending and borrowing. The central bank could calm markets by pledging counter the structural sources of inflation, and return to the 2% trend on a set schedule. It would also prescribe how they’re going to do it. “Every month these numbers come in, the closer the market participants get to thinking the Fed isn’t committed to the 2% goal,” concludes Luther.

The Fed’s Hobson’s choice

Imagine that we arrive in 2024 or 2025, and inflation’s still boiling at today’s 3%. The trajectory’s holding steady, not trending to the golden mean of 2%. Because the Fed’s dawdled so long, only lowering the monetary hammer would achieve 2% trajectory to where, as of now, the central banks says we should be. “That would involve much higher ‘real’ interest rates to cut consumer demand, leading to a decline in production and wages. It would be a classic recession,” says Luther. The increase in inflation-adjusted rates would be especially hard on pricey growth stocks, where investors are counting on giant future cash flows. Competition from better-yielding bond would prompt investors to pay less for each dollar in far-out profits, pounding PE multiples. Naturally, bond prices would crater as well. Mortgage rates would return to the 5% to 6% range, killing the current boom and flattening prices for years.

Or, the Fed could take the low road and skirt the agony of a hard times. But embracing inflation of 3%-or-higher creates its own set of problems. Suppliers would avoid long-term contracts that provide their clients certainty on their future input costs. “Those suppliers would stand to lose money if they committed to multi-year contracts, and inflation raised their costs a lot more than they anticipated,” says Luther. The bigger worry: America would become a far riskier place to do business, chiefly because consumers, companies and investors could no longer rely on the Fed to keep purchasing power steady, a pillar of our economic might. More uncertainty raises the “equity risk premium,” the extra investors are willing to pay for stocks over super-safe Treasuries. A rising ERP means lower multiples, and lower equity prices. “If the Fed permits higher inflation to avoid recession, we know that it conducts policy not the way it promised, but the way it sees fit at the moment,” says Luther. If the Fed’s gone this far, market participants will fret, who knows if it will allow inflation to race even faster?

Investors want to see the Fed as a sailing ship on a clear course to a fixed destination, not a windblown vessel tacking all over the place. The captain won’t tell us where the ship is headed. The passengers on this lurching journey are America’s companies and investors, and they’re getting worried that a boat once steered by master mariners has lost its compass.

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