Inflation is Falling Faster Than the Fed Thinks

Stocks opened higher today (Dow +300 pts; SPX +1.2%), leaning toward growthier sectors like technology and communications. The VIX fear gauge has fallen back from 27 to 23 in the past week. This comes despite a steady trickle of speeches from Fed officials preparing us for more monetary tightening. Currencies and commodity prices are moving today. The dollar is sharply lower after the European Central Bank mimicked the Fed by raising interest rates by .75% (see below). This is pushing gold up .8%, and crude oil up +3% to $86/barrel. Oil might also be reacting to a report that certain Kazakh oilfields are offline for “maintenance.” Kazakhstan supplies about 1% of the world’s oil. Bonds are catching a bid across the board—Treasuries, corporates, junk. This could be nothing more than a relief rally after August’s savage beating.

Despite high inflation and slowing growth, the US dollar has absolutely dominated other major currencies this year. Certainly it reflects the relative stability and strength of our economy vs. China and Europe. On balance a stronger dollar is positive for our economy as it attracts foreign investment and lowers the cost of imported goods (helping reduce inflation). But it also restrains sales and profit growth for US companies doing business overseas. Microsoft (MSFT) specifically called this out during its last earnings conference call. So with the dollar at a 20-year high, stock traders are happy to see a reversal this morning.

Bloomberg’s latest weekly survey of US economists reveals falling inflation expectations. Respondents now expect core inflation—excluding food & energy—to average 2.7% next year, and fall to 2.4% in the first quarter of 2024. The Federal Reserve’s own projection calls for a more gradual return to normal inflation levels: 3.2% next year and 2.3% in 2024. Currently, the same measure of inflation is running very hot at 4.6%. Who is right? I’m guessing Bloomberg will prove more accurate. A quick survey of the Treasury Inflation-protected (TIPS) market concludes that inflation will soon begin to moderate rapidly. TIPS breakeven implies 2.2% average inflation over the next two years! That’s essentially smack-on the Fed’s long-run target of 2%. This is important because inflation is in the driver’s seat of this bear market in stocks, bonds & housing. The quicker inflation returns to something approaching normal, the less damage the Fed will have to inflict on the economy.