The ‘Then What?!’ Scenario

If you’re looking for a reason to worry (and who isn’t, right?) you might consider the possibility that at some point early next year, inflation in the US stalls on the glide path lower.

Price pressures have unquestionably broadened out. This isn’t just about being patient and waiting for the turn in energy prices and the normalization of supply chains.

Food prices aren’t showing much in the way of moderation, which is extremely problematic, and gauges designed to remove outliers and capture the underlying trend rose last month (figure below).

In addition to hitting new highs on a 12-month basis, the Cleveland Fed’s median and trimmed-mean inflation gauges each posted MoM gains in July that outstripped the monthly prints on the BLS series, even as they, like the “official” figures, cooled from the torrid sequential pace seen in June.

The figure (below) is from TD. It gives you a sense of how COVID-disrupted and re-opening categories are impacting the headline prints.

“We continue to expect prices to register firm gains in the near-term, especially for the core segment on the back of a still solid backdrop for services prices, led by shelter,” the bank said.

Similarly, Nomura’s Charlie McElligott wrote Thursday that “broad-based pressures and the risk of a wage-price spiral from such a tight labor market will make evidence of a ‘clear and convincing’ drop in inflation back to the arbitrary 2% target unrealistic in the medium-term.”

For McElligott, the most worrisome scenario is a situation in which a market that generally expects lower average inflation looks up in March and discovers that progress towards the Fed’s goal is becoming harder and harder to come by.

“The sequencing I’m most worried about is likely early / mid Q1 2023 [when] the market sees just how ‘structural’ much of the embedded inflation has become, and that we are stuck in a much more shallow inflation glide path, which stalls in the 4% to 5% range, unable to revisit ‘target,'” he wrote, in a Thursday note. In such a hypothetical, the market may discover that shelter prices “continue to contribute” on a lag, while “structural shortages” in energy and labor “keep those inflation inputs firm as well.”

That latter point is absolutely crucial. I can’t emphasize it enough. This goes back to one of my favorite discussions: The cost of procrastination.

Late last year, I likened the labor shortage (and attendant upward pressure on wages) to the combustible situation in energy. After reaffirming my support for the implementation of a Progressive economic agenda as the only way to prevent inequality from spiraling so far out of control in America that the country ends up experiencing acute societal breakdown, and after an obligatory nod to the fact that absent a rapid about-face on energy policy, our biome is doomed, I wrote that,

Procrastination has consequences, my unblemished collegiate track record of penning publication-ready papers the night before they were due while finding my way to the bottom of a Hennessy bottle notwithstanding. Decades of procrastination on climate initiatives likely means the world will experience “significant energy storms [with] prices much higher at times, and prone to turbulence pretty much all of the time,” as SocGen put it in November. Decades spent pursuing supply-side “reforms” and instituting an unbridled version of capitalism free from common sense guardrails, left America to rewrite the rules virtually overnight when the pandemic hit, with predictable results. Haphazard policymaking begets suboptimal outcomes even when (and, in many cases, especially when) the policy shift is well-meaning.

The article from which that passage is excerpted seems particularly prescient eight months later, but never mind that. I assiduously avoid pretensions to prescience, and you should too. We boast about the times we got things right, and forget all the times we didn’t. The latter outnumber the former for all of us — and not by a small margin.

My point in December was that the labor market might not normalize. Soon or possibly ever. And that energy prices may become totally unpredictable going forward, as opposed to just mostly unpredictable.

That ties directly into McElligott’s concerns about what could end up being persistent interruptions on the path to on-target inflation due to “structural shortages” in labor and energy.

Describing a prospective stalling on the path to slower price growth midway through 2023, McElligott said, “This is the ‘Then What?!’ scenario which should keep Fed participants up at night, and leave them biased to run ‘restrictive for longer’ in the meantime.”

Many traders and investors, Charlie said, will continue to assume that the Fed’s tightening cycle will end by Q2 of next year. “So the risk is that after a pause — which [could be] mistakenly perceived as a premature ‘all clear,’ ‘dovish pivot’ — the Fed could in fact need to tighten again, and risk one last shot at ‘risk-off’ on the forward policy uncertainty thereafter.”