I was looking back to a column from July of last year and lamenting that inflation is rearing its ugly head, but the Fed has not seemed to notice. Well, we all know what happened with that. It took them a year to respond, and, by then, inflation was entrenched. The Fed then cranked into high gear and raised interest rates faster than ever before, albeit starting at a level dangerously low. 

Interest rates had been held too low and too long, and they rose very fast but far too late. Most CEOs believe that a bad recession is inevitable now. Certainly that will be the case if the Fed continues on with its policy. 

I am not sure that the Fed will continue to hold their line, though. 

What the Fed has done to date would have been good … a year ago. We can even the ups and downs of the economy if we stay ahead of it. But just like what happens when one responds too slowly to a skid, when one does finally respond, it can actually make matters worse. 

Anticipation is so important because monetary tightening takes at least a year to work. Higher interest rates discourage new projects from going forward and new homes from getting built. However, it takes about six months for the proceeds from approved and funded loans to translate into construction and jobs. Federal Reserve tightening this fall won’t have any effect in reduced activity until early spring. Meanwhile, labor demand will remain relatively unchanged. 

Nor will the quickly weakening used home market have much of an effect for six months or so either. Home prices may drop because of market softness, but the consumer price index has as only a miniscule component the mortgage payments on recently financed homes. It will take an average of six months later, and upwards of a year for rentals and leases to slow their rate of rent increases. 

These are the reasons why it is so important to stay ahead of inflation, by upwards of a year. 

So, why is the market so giddy even if the Fed policy has yet to bite? They are finally realizing what we have been saying for the last couple of months. Conventional thinking focuses on the year to year increase in prices to calculate the inflation rate. In the months from July 2021 to June 2022, the economy came out of its COVID funk and caught up on a lot of pent-up demand, but with a supply chain slow to respond. Then, Russia’s invasion of Ukraine forced up energy prices. These forces combined for hefty price increases from July 2021 to April, 2022. 

But, as we have discussed, month-to-month inflation from May, 2022 onward is actually quite moderated. If we annualize these monthly inflations to construct yearly equivalents, or even concentrate on quarterly price increases, we actually see the inflation rate has fallen to pretty traditional levels. By the time November consumer prices are in, I believe we will find that the annualized six month inflation rate will be a little over 4% next month, and below 3% at year’s end. 

In other words, the Fed’s late effort to chase its tail will have little effect by the time the supply chain has mostly fixed itself and the big energy escalation has moderated. Paul Krugman has recently come to that same conclusion. 

The market now realizes that the supply side and energy-driven inflation is abating. There will be some remnants of wage-push inflation, but the Fed’s late acts should help moderate those, at least psychologically. The bottom line is that the market believes the Fed may see that inflation has stabilized and they may not need to keep chasing their tail. 

Of course, it is unlikely that the Fed will acknowledge their far-too-late response, and may even take credit for bringing down inflation. I’ve been around the block long enough to know that a lot of people take credit for things they didn’t do, and fail to take responsibility for things they did. I guess that’s politics. The most important thing, though, is that we may not need to suffer the deep recession that was heading our way. 

I am not so sure that we will have a completely soft landing. But, with increased caution from fearful spenders, no more fiscal folly from the political parties, and decreasing dependency on fossil fuels, we may actually pull this off without terrible pain. At least that is what the market is banking on.