At the Money: Knowing When You’ve Whipped Inflation. (March 6, 2024)
Investors hate inflation. How can they evaluate what inflation means to the Federal Reserve and possibly future rate cutes?
Full transcript below.
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About this week’s guest:
Claudi Sahm is a former Federal Reserve economist best known for the rule bearing her name. She runs Sahm Consulting.
For more info, see:
Sahm Consulting
Stay-at-Home (SAHM) Macro!
Substack
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TRANSCRIPT
Barry Ritholtz: Consumers hate inflation. It reduces the buying power of their cash, it sends rates higher, and it makes anything purchased with credit, even more expensive.
During the COVID era, people locked down at home, shifted their consumption from services to goods; supply chains became snarled; then we had a massive fiscal stimulus. And THAT is what led to the giant inflation spike of 2021 and 22.
The good news is inflation peaked in the Summer of 22 and seems to be on its way back to normal. But that raises an important question for investors: Is inflation over and is the Fed done?
I’m Barry Ritholtz, and on today’s edition of At The Money, we are going to discuss how to look at the data and think about inflation.
To help us unpack all of this and what it means for your portfolio, let’s bring in Claudia Sahm. She is a former Federal Reserve economist and creator of what is known as the Somm Rule. Claudia, let’s start with a basic definition. What is inflation?
Claudia Sahm: Inflation is the increase in prices, the percent increase in prices.
Barry Ritholtz: So, we hear about all sorts of different measures of inflation. There’s CPI, the Consumer Price Indicator. There’s PCE, the Personal Consumption Expenditure. There’s core inflation. There’s like half a dozen; which should we pay attention to?
Claudia Sahm: It’s absolutely important that we have a pulse on where inflation is and where it’s going. So, If something is a complicated phenomenon, you’ve got to have multiple ways of looking at it. And the questions differ some. So the two, the Consumer Price Index versus the Personal Consumption Expenditure Index, the CPI is pretty close to out-of-pocket expenses.
And, the difference then is the Personal Consumption Expenditure Index, which is the one the Fed uses and its 2% target. It takes a bigger picture on what’s the price of all the things that we quote-unquote consume. Healthcare is a big example of this. In CPI, it’s only out-of-pocket medical expenses. In PCE, it’s not. It’s also the prices of things bought on our behalf, like our health insurance, also by the government with Medicare.
So, these are two different things. CPI matters a lot to people because, I mean, that’s really what’s coming out of their pocket directly. It’s also what’s used to index Social Security benefits every year. So these are both very important. And this issue of total versus core, and core is in the inflation taking out the food and energy. So the reason we talk about core, it’s not that the Fed is targeting core. The Fed’s mandate is with all prices.
What CORE is, is it helps us have a sense of where inflation might be going. Food and energy can move all over the place, and you don’t want to get head faked by what’s happening with gasoline prices, per se. So, the Fed needs to have a sense of where things are headed with inflation — because rates are a tool that takes a little bit for it to work its way through the economy. That’s the reason that CORE gets as much attention as it does.
Barry Ritholtz: So we saw inflation tick up through the 2% target, I wanna say first quarter of 2021. On its way up to just about 9%. It felt to me very different than the inflation we experienced in the 1970s. What does the data say? Is this inflation similar to what we saw in that decade or very different?
Claudia Sahm: First in the 1970s, we had high inflation for many years. It was a kind of slow burn on the economy. We also had high unemployment at various times in that period. And it, it had this, there was a lot of demand behind it. There were some energy shocks. Like, there were other things going on. [Oil embargo in 73]
Sure. But we talk about them, we had the guns and butter, as they call it. So there was a big effort with Vietnam, and then there was a big Great Society, like, a program of spending. This time, we did have massive fiscal relief. Everything from the CARES Act through the Rescue Plan was pushing out a lot of money to help people in small businesses and communities.
We also had these very strange disruptions, and, and you talked about several of them. I would add to the list, that when we shut down the economy, not only did people switch from services to goods – they didn’t spend as much. And so you had this big pent-up demand, even from people who did not get the fiscal stimulus.
So when the vaccine started rolling out in 2021, you had this massive pent-up demand that came out at the same time relief was going out. That, you know, the pent-up demand, we talk about the quote-unquote revenge travel. [Right, the summer of travel]. Yes, and so that had, that was, shutting down a 20 trillion-plus economy is just unfathomable. And it turns out that flipping the switch back on was really hard. And one place that that difficulty showed up was in inflation.
Barry Ritholtz: So investors who are tracking these various measures of inflation. What should they be paying attention to when inflation is on the rise?
Claudia Sahm: It’s very important right now to not get hung up in every single data release. We’ve seen a lot of progress with inflation coming down. There. is absolutely going to be turbulence on the way down – not every, not every data release is a good one.
And the Fed knows that. So, I mean, this is not, uh, news to them. I do worry sometimes that investors get pulled around by the latest number.
It’s about looking for the trajectory, like the momentum, and inflation is complicated. It is important to look under the hood at what’s going on.
Barry Ritholtz: So you mentioned the Federal Reserve. Obviously, we can’t talk about inflation without mentioning them. They have a dual mandate, full employment, and stable prices. What does Jerome Powell, the Federal Reserve Chairman, pay attention to when he’s looking at inflation?
Claudia Sahm: It’s coming down. I mean, the Fed is going to keep going until they have inflation at 2%. In December 2023 at their last meeting, for the first time, there was a little more of this tone like, “Oh, we’re watching unemployment too.”
So they do realize they are making a lot of progress towards 2%. It is essential that they get both sides of their mandate. The Fed is not just about inflation and Jay Powell, in his entire tenure as Fed chair, has really emphasized, hey, we know we have that employment mandate. And that’s, that’s heartening.
And that’s, that’s the law, right? That’s what Congress gave them as a dual mandate. And yet, right now, the Fed, in terms, of the decisions about when to cut interest rates, and how low they go next year, is all about the inflation data.
Barry Ritholtz: So let’s talk about the Fed Open Market Committee and the raising of rates.
Typically, when the Fed raises its rates, It slows the economy by making consumer credit more expensive. This is credit card debt, car loans, and mortgages, and that tends to slow the economy. But it also comes with what everybody calls “a long and variable lag.” Tell us about why it is so difficult to tell when Fed policy action makes its way into the economy.
Claudia Sahm: The Fed’s policy tools are very blunt, and over time, they have made it even harder to figure out what’s going on.
So the Federal Reserve right now has raised interest rates well over five percentage points. They did it very quickly. The discussion turned late last year to when are they going to cut, when are they going to reduce interest rates. Okay, Jay Powell goes out after the committee meeting in December 2023 and does a press conference – another one of the Fed’s new tools is communication policy, like what the, what J Powell says.
As far as I was concerned, as someone who listens to a lot of Fed speak, J Powell’s press conference was basically, pop the champagne bottle. I mean, it was just a very, like, we’re headed towards this off landing, we’re going to cut. Without any specifics, right, I don’t want to oversell what he said, but I mean, markets, heard a lot of what I heard. Interest rates have moved down considerably. The Fed hasn’t even cut yet. This is where they say maybe those aren’t so long and variable lags. They might actually be some pretty short lags because the market’s already ahead of them
But it’s because the Fed told them. Like, there’s communication. It’s not just the Fed or the markets made it up. Like, they’re listening. But the Fed doesn’t know what it’s going to do.
Barry Ritholtz: So, I’m glad, glad you brought up that aspect of it, of the jawboning. For, for some younger listeners, I remember when I started. Forget press conferences, there wasn’t even an announcement that the Fed had changed interest rates. The only way you found out about it is you saw it in the bond market.
The world today is so different than it was in the 1970s, and maybe that’s why so many of the economists who came of age in the 1970s seem to have gotten this inflation spike wrong – they saw it as a structural long-term issue, but it seems to have been transitory. Tell us a little bit about team transitory.
Claudia Sahm: I’m a card-carrying member of team transitory. I would never have used the word transitory. Economists should not be allowed to give names to anything.
Barry Ritholtz: Well, everything is transitory if you have a long enough timeline.
Claudia Sahm: I had someone on Twitter ask me, aren’t we all transitory? And I’m just like, let’s, let’s stick to inflation.
Barry Ritholtz: Eventually, heat death will take over the universe and everything will end. But on a shorter timeline, there’s a difference between structural inflation, like we saw in the 70s that lasted almost a decade, and this up and down inflation that seems to have lasted less than two years.
Claudia Sahm: Absolutely. The concern in this cycle, that frankly, I think, that was frankly overplayed was the idea that we were getting embedded inflation. That we would have an inflation mentality like set in, after a decade in the 1970s. That was the big concern and that, that’s, the embedded inflation was (then Fed Chair) Volcker’s reason for just, really pushing up interest rates. And without a lot of warning, to your point.
But this time, if you have temporary disruptions, and they’re the form of these supply disruptions that really aren’t about the Fed, typically, if you have those disruptions, like you would have during a hurricane. The Fed is supposed to look through it, in that they don’t react. That was what they were doing in 2021.
They’re like, this is not us. Unfortunately, these disruptions took a much longer to unwind. Jay Powell talked about it as, yeah, it was two-year transitory, not one year. That was too long, right? And that’s why the Fed did get in. And they were concerned that as inflation stays high, people would get it in their mind. “Oh, this is just the way it is.”
We never saw a sign of that. It’s extremely important. And the disruptions, the supply disruptions really have worked themselves out. Now there’s a question. I mean, the, the fear mongers will not go down without a fight that it could be that what is left in the inflation is demand driven and is about the Fed and could get embedded.
That’s not my read of it, but it’s a risk people should pay attention to. Ed Yardeni has this really interesting observation: “Inflation tends to be a symmetrical phenomenon. It tends to come down as quickly or as slowly. as it went up when measured on a year over year basis. We see this consistent pattern in the CPI inflation rate for the US since 1921.”
Really quite fascinating.
Claudia Sahm: Yeah, I sure hope we get that. You know, I, I’m, I’ve become so skeptical of historical patterns just because the, you know, and, and the, it was the 1918 pandemic, so you gotta go back a little further to what we’ve seen. But it makes a lot of sense because inflation is not just this blob, like there are, there’s a lot of pieces under the hood, and if you have a very, like, quick shock, like we had, and if there’s supply, or something that’s very indicative of a temporary. You really jack it up, and then it comes back down quickly; as opposed to if it’s demand, you have the inflation mentality, it like, you slowly build that up, and then it can be hard to shake.
Barry Ritholtz: So, last question. What should investors be on the lookout for when it comes to falling inflation?
Claudia Sahm: Since the summer of 2022, we have seen steady declines in inflation, and even the momentum picking up some towards the end of last year. What we should be looking for is that momentum to continue.
If we get stuck in the first quarter of this year, the Fed is going to react very differently, maybe could even raise rates. So what we’re watching is, hey, is this more of these disruptions unwinding? In which case, they could keep it down, coming down quickly, or have we gotten into a place where this somewhat above the target inflation is happening and the Fed is going to get two percent.
The Fed knows how to get two percent and, but, but it may not be pretty.
Barry Ritholtz: Really, really interesting. So to wrap up, investors and consumers who are concerned about inflation should be aware of a few things.
First, Be aware of the recency effect: Don’t let any single month’s data point throw you off. Use a moving average. This data series is very noisy. At any given month, you can have a really good or a really bad number. You have to look at the trend.
Second, when it comes to the level of inflation, Look at CPI on a year over year basis. That’ll give you a sense of where we are over the long term. And lastly, if you’re a consumer concerned about inflation, take an honest look at your wages. Sure, inflation has risen, but so too have salaries. In fact, the salary component of inflation is significant. Hopefully your salaries have risen enough or more than inflation to maintain your buying power.
I’m Barry Ritholtz. You’re listening to Bloomberg’s At The Money.
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