There is only one way to solve the U.S. inflation issue, and it won’t be a smooth transition.
Consumer prices rose 8.5 percent year over year in March, according to central bankers and economists, but the Federal Reserve can still bring inflation back down to its 2 percent target without harming the economy. That expectation is reflected in the Fed’s own economic projections, and according to a recent survey by The Wall Street Journal, only 28% of economists expect a recession in the coming year.
The prevalent opinion that inflation was only temporary in the past is reminiscent of the current consensus view that a so-called soft landing is not only possible but also likely. The current macro narrative is predicated on the notion that inflation has reached its peak.
However, the war in Ukraine and Covid lockdowns in China make the peak-inflation argument even more contentious than it already would be, based on domestic shelter prices alone. Inflation is at a 40-year high and feels worse than the headlines look to many businesses and consumers, given how quickly food, energy, and shelter prices are rising.
George Goncalves, head of U.S. macro strategy at Mitsubishi UFJ Financial Group’s institutional client group, asserts that “we all know monetary policy on a good day isn’t the most surgical and clean.” The Fed’s job is only getting harder, in his opinion, given the challenges it is currently facing and how long it has put off addressing inflation.
Two plausible situations
There appear to be two plausible outcomes for the upcoming months. Both come to a crashing end. Either the Fed combats inflation effectively enough, or it doesn’t, which leads to the stagflationary mix of high prices and slow growth that invariably precipitates a worse recession.
Behind the still-rosy appearance are economic statistics that seem solid. Apart from the fact that the GDP shrank in the first quarter, adjusted wages are falling, and there are indications that consumers are depleting their savings, there are two issues. Data on growth are first inflated. Josh Shapiro, chief U.S. economist at MFR, points to a recent report on durable goods, which revealed that orders for nondefense capital goods other than aircraft increased 9.7% in March compared to February. Solid, except when you consider that during the same time period, the producer price index for private capital equipment rose by 8.7 percent. The story of retail sales is similar: They have remained flat for the majority of the past year when adjusted for inflation.
Housing market statistics
Then there are reports on the housing market, where strength is exactly the problem. Housing starts and building permits increased in March despite mortgage rates rapidly reaching their highest level since 2010 and the Fed’s declaration that it would aggressively raise rates and reduce its balance sheet to fight inflation. In accordance with additional data released over the past week, home prices increased at the fastest month-over-month rate ever recorded in February, rising 20.2 percent from a year earlier to an all-time high.
According to Apollo Global Management’s chief economist, Torsten Slk, despite the fact that mortgage rates are rising quickly, they are essentially having no impact on the housing market. The Fed must reduce housing prices, which account for 40% of the CPI, in order to reduce inflation. However, a fifth of GDP is also made up of housing. Furthermore, the so-called wealth effect is closely related to real estate because more people own their homes than have a sizable amount of stock market exposure. The housing market has been stoked over the past two years as the pandemic drove people to suburbs and exurbs that are chronically low on inventory and Fed intervention sabotaged mortgage rates. In reality, it will take a lot of tightening to cool the market. Officials from the Fed have started to admit that they have a housing problem and have even hinted that they may eventually sell the mortgage-backed securities they have been buying for the past two years.
