- High and still-rising core inflation across developed countries
- Focus on Jackson Hole meeting starting Thursday
- Fed has not been challenged yet, but eventual crisis is likely
- Against that backdrop, equity volatility looks interestingly cheap
Whatever happens with the data this week, it is going to be secondary. That’s not merely because there isn’t anything on the docket that will illuminate the inflation picture very much—Friday’s core PCE deflator is a July number, so there isn’t really any new information there—but because next weekend brings the Jackson Hole US Federal Reserve conference.
The proximity of Jackson Hole means that we will be limited to navel-gazing, and perhaps some retroactive parsing of data from last week. In the inflation realm, the most relevant of last week’s reports was not even domestic but rather the inflation reports from the UK and Europe.
The UK reported headline inflation over 10%, and core CPI of 6.2%—fully 0.3% higher than expectations and matching the high from a few months ago. As the chart below shows, core inflation is rising uniformly across the major developed economies.
Source: Bloomberg
Now, it isn’t surprising to see headline inflation highly correlated across economies, since the main driver of headline inflation volatility is energy and all developed economies consume a lot of that. But when core inflation is so correlated, it bears asking why.
The current Administration, as well as the central bank, has enjoyed pointing to other economies and saying “see? It can’t be something we did because everyone else has inflation too.” That statement is both true and false. It can be something that fiscal and monetary authorities did that caused this synchronized spike in inflation. It just can’t be something that was unique to the US.
As we know, the Fed and the Congress/Administration were not the only bodies in the world that (a) spent like drunken sailors and (b) printed the money to do so. M2 growth reached 26.9% year-on-year (yoy) in the US. But it also reached 11.6% yoy in Europe and 15.4% in the UK. None of that is consistent with stable prices, and no one should be surprised that in all of those economies, the price level is running away to try and reach a level consistent with the monetary float.
It remains baffling to me that central banks refuse to recognize this fact, and respond aggressively with monetary restraint targeted at the aggregates. Well, maybe when the next generation of policymakers reads about this in their history books, they’ll learn something. It’s clear that the current generation hasn’t learned anything from their history books!
Taking a Step Back…
The end of this week sees the annual Jackson Hole Fed symposium, hosted by the Kansas City Federal Reserve in Jackson Hole. This has become a platform at which major policy and/or philosophy shifts are announced by the Fed Chairman, so implied volatilities at least in fixed-income space should be relatively elevated into the end of the week at least (see chart of the MOVE index).
In general, fixed-income vol seems curiously elevated for an August—Jackson Hole or no. I think that investors are perhaps not fully convinced that the lows for the bond market are in. Yields on the 10-year note are creeping back up towards 3%. There is clearly some cognitive dissonance going on between the Fed’s clear and unanimous talking points that the market’s pricing of short-term policy rates peaking and then declining in early 2023 is in error, and the market’s pricing of longer-term rates at levels very near current policy rates and well below inflation. 
Source: Bloomberg
You can expect Chairman Powell to state very clearly that the Fed is going to keep on hammering until inflation is clearly headed back to the Fed’s goal. The market so far has been ignoring him, but the high levels of implied vols and the slowly rising longer-term interest rates suggest to me that people are starting to listen.
The thing is, the Fed and investors in the market are like chess players with different levels of expertise. The Fed is looking one move ahead.
“Inflation is still elevated, and we are going to keep hiking until it comes down.”
The market (apologies for the anthropomorphism) is looking two moves ahead.
“Inflation is still elevated. The Fed is going to keep hiking. But eventually they will crush the economy and at that point they will take the foot off the brake and move it to the gas.”
The Fed thinks it understands that is what the market is saying, and they are spending a lot of time stating as clearly as they can that the market doesn’t understand the strength of the Fed’s will. But the market, again, is another move ahead. The Fed does not understand that it will have not been tested. As Mike Tyson said, everyone has a plan until they get punched in the mouth and the Fed has not gotten punched in the mouth.
They have not been challenged by opinion or by circumstance: the popular consensus is that inflation is too high; financial market adjustment has been gentle and orderly. Popular opinion though will change when the unemployment rate eventually begins to rise. And the market is due to become less-orderly as the balance-sheet shrinkage starts to accelerate in the months ahead. The balance sheet is not shrinking quickly, but it is monotonic (that is, only decreasing).
Inflation is going to come down, but core and median will not even begin to approach their target in 2022, nor in 2023. As interest rates go up, and the economy continues to slow, eventually markets (and popular opinion) will react. There will be a crisis, almost certainly. There always is. And that’s what high implied volatilities are saying; that’s what the ‘peak’ in the forward curve is saying. The Fed will not be able to march interest rates to 5% without a challenge. Historically, they have been found wanting when that challenge was presented.
While interest rate implied volatility is getting high, options still look relatively cheap in equity land. I suspect it’s worth spending a few pennies on a parachute.
Disclosure: My company and/or funds and accounts we manage have positions in inflation-indexed bonds and various commodity and financial futures products and ETFs, that may be mentioned from time to time in this column.