The Sticky Part of Inflation

Jerome Powell talks (again)... The sticky part of inflation... On a lighter note... Debating the inverted yield curve... An idea worth thinking about... But don't take it at face value...

Yes, that's what I meant...

Today, Federal Reserve Chair Jerome Powell reiterated that what he said last week coming out of the Fed's policy meeting – inflation is slowing down – was actually what he meant to say... He said the word "disinflation" 11 times, in fact.

I (Corey McLaughlin) find it almost funny that he needs to do this. Still, if you listen close enough and parse the confusing parts of his comments, you can get pretty close to understanding what he's trying to say... most of the time.

In any case, in a nearly 40-minute interview in Washington, D.C., the Fed chair was asked point-blank about his current line of thinking when it comes to monetary policy – especially after a stunning jobs report on Friday that lowered the unemployment rate to 3.4%.

That might suggest that inflation won't be slowing down moving forward, and thus the Fed could hike interest rates even more than it has already indicated... To Powell, though, the report didn't change much since he last spoke publicly less than a week ago.

If anything, the recent jobs report confirmed the Fed's current stance...

As we've said – and as the central bank has made clear for months – the plan is to raise benchmark rates at least a little bit more to around 5%. Then the Fed will leave them around there for a while until it can determine what happens to the economy.

As Powell said today about Friday's jobs report, which showed about 330,000 more new jobs added to the economy in January than Wall Street expected...

It underscores the message I was sending at the press conference and the meeting... The message we were sending was really that disinflationary process has begun... but it has a long way to go...

Later, in today's interview at the Economic Club with billionaire David Rubenstein – co-chairman of the Carlyle investment firm – Powell got into details about the Fed's preferred inflation measure: the personal consumption expenditures ("PCE") index...

This convoluted government acronym matters to investors...

Powell noted that "goods" inflation in the PCE measure has started to slow down, in part because the PCE includes such products as cars and furniture, which are sensitive to interest rates because many are purchased on credit. And he expects the numbers linked to housing to come down in the second half of this year.

However, he explained that there's still one more big part of the economy that hasn't started slowing down yet.

That's the "services" sector outside of housing – which makes up 56% of PCE and includes things like food, health care, and hotel and travel costs. This area of the U.S. economy has shown no signs of disinflation yet, he said. So that's why...

We think this will be a process that takes a significant period of time... We need to be patient. We think we're going to need to keep rates at a restrictive level for a period of time before that comes down.

Later, he explained a bit more about his thinking that we hadn't heard before on the origins of the inflation mess and what concerns him today...

The whole thing began... inflation began with people not being able to buy services [and] instead buying goods, and then global supply chains collapsing and you couldn't get goods, and prices of goods went up. That's where it started.

That is now starting to get better as supply chains are improving and as people are rotating their purchases back to services. You move on, though, we're not seeing in housing services, which is rent or the imputed cost of house ownership, but we expect to see that. We need that to happen... It should come in the second half of this year.

Then the biggest piece of it and what I worry about the most is when are we going to see disinflation, or declining inflation, is core services, ex-housing? That's what I worry about.

He concluded by also saying he also worries about "another exogenous event" that could throw off the path of inflation coming down. Powell said...

It's a risky world out there with the war in Ukraine and the reopening of China. Those are things that can affect our economy and the path of inflation.

In other words, if you're hoping for rate cuts, you're going to be hoping for a long time – probably until 2024, based on additional comments Powell made today about rate plans. He even mentioned once that they could go higher than the currently projected peak if necessary, though not that they would.

Notably, Powell also said – for the first time I've heard – that the Fed plans to keep trimming its balance sheet for "a couple of years." He didn't sound like a guy who's ready to stop fighting inflation yet... But once again, he also didn't take the opportunity to say the markets were reading him wrong by rallying off what he said last Wednesday.

The benchmark S&P 500 Index jumped 1% as Powell started talking, pulled back to a little below breakeven on the day as he finished, and rallied over the final two hours of trading to close up 1%. So it goes...

Right now, bond traders expect at least one more 25-basis-point hike at the Fed's next meeting in March. After that, they think the central bank will either "pause" or raise rates by another 0.25%... unless the economy shows signs of revving back up into overheated mode again.

That could mean further rate hikes and more pain ahead for stocks. But if it doesn't happen, that could be fuel for the bulls...

On a lighter note...

Maybe we're better off just lining up Fed chairs by height to see the truth...

Financial and technical analyst Mike Zaccardi shared the below image, first published a few years ago, on social media the other day. It shows a strong correlation between the height of Fed leaders, past and present, and the track of interest rates since 1979...

The 10-year Treasury yield, charted above, of course has gone higher in Powell's tenure, following the trend. As of today, the 10-year yielded 3.66%, higher than the median of the Ben Bernanke era...

Please, don't take this chart too seriously... unless you really want to. Just remember that long-term trends might be breaking – and that we might want to pay attention to the heights of the next potential Fed chairs to see if this keeps holding true.

Some more talk about the yield curve...

In yesterday's Digest, we mentioned how the yield curve is still inverted, suggesting more economic trouble ahead. In response, Stansberry Alliance member Patrick H. wrote in with these thoughts...

I just read a piece in one of the many investment articles I receive and the individual who first published the inverted yield curve analysis said he believes this time it is highly probable that the inverted yield curve scenario might be false.

He gave a number of reasons but it might be time (at least for this year) to put that story to bed. Apparently, low unemployment has made the biggest difference.

Thanks for your thorough analysis in the Digest.

Patrick, thanks for the note, and you are spot on. I'm not sure if this is the piece you're referring to, but our colleague Brett Eversole discussed precisely what you're talking about in an issue of the free DailyWealth newsletter last week.

Campbell Harvey, now an economist and finance professor at Duke University, is credited with popularizing the "inverted yield curve" indicator in a dissertation he published in the 1980s. He was the first to widely show that short-term yields rising above long-term yields accurately predicted every recession since 1968.

This is timely, of course... because as we've been able to say since last July, the yield curve is inverted.

What's considered a benchmark spread in the bond market – the 10-year/2-year – has been upside-down for seven months, the longest consecutive stretch since the start of dot-com bubble burst.

Even the 10-year/3-month spread has been negative for more than three months, which is considered a more imminent recession indicator. History would suggest a recession is a certainty... and soon.

But in a recent interview with Bloomberg, Harvey said he has "reasons to believe" the bond market indicator he discovered could be giving a false signal this time.

Here's why this might be a 'false signal' now...

As Patrick noted, one of the reasons Harvey suggested is the strong jobs market... We simply aren't seeing massive layoffs yet. If anything, the labor market is getting a bit stronger, with unemployment dropping to 3.4% on Friday, a new 53-year low.

Another factor to consider, Harvey said, is that the inverted yield curve is so widely followed these days that it might lose some of its predictive power. Because it can drive some "risk off" market behavior, the yield curve may have become a factor in the markets itself.

If you ask me, there might be some bias on this second point. Of course the inventor of an indicator might think more people make decisions based off it than they actually do. Our skepticism aside, here's what Harvey said in the interview...

When you put all this together, it suggests we could dodge the bullet, avoiding the hard landing – recession – and realizing slow growth or minor negative growth. If a recession arrives, it will be mild.

As Brett wrote in DailyWealth, it's significant that the person credited with a widely followed indicator is raising the idea it could be giving a false signal today...

Harvey's ability to flip his position – on an indicator that he discovered – is impressive. Most folks aren't willing to do that, even in the face of the evidence. And as investors, we need to pay attention.

Everyone expects a recession. It has become the consensus bet. The problem with that is one we know well... When everyone is certain of an outcome, it's less likely to occur.

The jury is out on what happens next...

But here are a couple things to think about no matter what happens... and a few ideas that might help you with portfolio decisions...

1. I haven't heard anyone ever suggest that an inverted yield curve is an indicator of any specific type of recession, just a recession. A "mild" recession is still a recession.

2. You could argue we already had a recession in the first two quarters of 2022 when U.S. gross domestic product ("GDP") contracted for six straight months.

I would not be surprised if the economy ultimately goes into an "official" recession in the next year. It generally takes nine to 12 months for the Fed's interest-rate policies to hit the economy, and the rate hikes haven't even topped out yet.

As I talked about last week, a strong jobs market isn't disinflationary, either. Wages are growing at about 7% per year. The Fed will likely keep lending rates high for a while to avoid the dreaded "wage-price spiral"...

That's why, as we wrote yesterday, a strong jobs market today is both good for the present and potentially bad for our future...

It means people aren't losing jobs, and an obvious recession is not at work yet. But it also means the monetary policy string-pullers may want to hike rates even more to cool inflationary pressures.

When it comes to what this means for your portfolio, the most useful thing to think about (again) is the relationship between stocks and the economy. Over the long run, stock prices tend to lead economic data, not the other way around.

This jibes with the idea that we were talking about yesterday from our colleagues Matt Weinschenk and Jeff Havenstein, that a recession is so "expected" at this point that many Wall Street investors have already priced that into the market.

This is an idea worth thinking about... That's why we wrote about it yesterday.

But so is this...

Whatever happens next, the inverted yield curve has proven its power again...

Remember, the 10-year/2-year spread inverted in July, and the major U.S stock indexes topped five months later. The bond market saw economic trouble brewing, and the stock market followed its lead.

In other words, you always want to pay attention anytime yields "invert" and manage risk accordingly... Now, we also want to pay close attention to when they begin to "revert."

I won't be convinced a healthier economy is in our future until negative yield spreads "bottom" for good and start turning around. This hasn't happened yet.

But there's no denying that over the past several months, yields on government bonds have been suggesting recession ahead – and prices of riskier stocks have been rising at the same time.

As I wrote yesterday, this pattern can continue... Things can get "less bad" as the economy makes its way out of the high-inflationary mess we've been in for the past two years. People who buy stocks like "less bad."

But things can get worse, too, because of unknown events or decisions (like the Fed's interest-rate policy) that haven't happened yet. If the central bank raises rates higher than currently expected, the economy and stocks are in for more pain ahead.

Add This Market to Your Watch List

The biggest growth story of 2023 has been three years in the making. And this week's Stansberry Investor Hour guest – Asia-based analyst Brian Tycangco – is at the forefront of it all...

Click here to listen to this episode of the Stansberry Investor Hour right now. And to catch all of the videos and podcasts from the Stansberry Research team, be sure to visit our Stansberry Investor platform anytime.

New 52-week highs (as of 2/6/23): RenaissanceRe (RNR).

We shared and answered today's big piece of mail earlier... Do you have a comment or a question on your mind? As always, e-mail us at feedback@stansberryresearch.com.

"Today, we're seeing the short-term pressure on prices. It's looking more like individual money is trading rather than investing which is driving prices. We are still in a period of time where corporate retirement plans with calendar year ends are funding accounts which supports equity fund inflows. I'd be hard pressed to believe younger workers are investing in bonds and bullion at this time when they're horizon period is 20+ years or more.

"I agree that the Fed policy is working and it's returned banks to profitability in lending which they certainly wanted and needed. It's foolish to think rates would remain near zero or 1%. You've brought up an interesting analytical on deflation versus disinflation. Time ahead will reveal this...

"I recall your comment about tuning out from CNBC and Bloomberg to focus on technical analysis rather than media. My primary concerns from media are actually more about the Ukraine war and possibly the Taiwan invasion. What troubles me is self-fulfilling psychology which the herd falls into which brings the events to further fruition. The problem is that this effects markets adversely.

"I'm a big believer in market psychology having a huge influence. It's a huge responsibility for our financial media. They tend to switch between doom or hope in 24-48 cycles. It's not exactly positive news for longer term (at least 1-3 year+) investors.

"Thanks for keeping our eye on the ball regarding investment time horizons and how we should invest based on this. It's a great way to remind even seasoned investors of the value of dollar cost averaging as a system for investing." – Paid-up subscriber Rodger G.

All the best,

Corey McLaughlin
Baltimore, Maryland
February 7, 2023