Why inflation has declined but the economy remains healthy

The December CPI report released today supports everything I've been saying for months. Inflation pressures peaked in June, with the year over year CPI registering 9.0%, the 6-mo. annualized rate 11.2%, and the 3-mo. annualized rate 11.0%. As of December those same measures were significantly lower, registering 6.4%, 1.9% and 1.8%. Quite an impressive decline! Inflation is no longer a problem.

The ex-energy version of the CPI showed the same decline, only on a smaller scale, with the peak also occurring in June: YOY 6.6%, 6-mo. 7.6%, and 3-mo. 8.6%. As of December, those same measures were 6.4%, 5.1%, and 3.5%.

The core version (ex food & energy) declined as well: June 5.9%, 6.8%, and 7.9%. December: 5.7%, 4.6%, 3.1%.

Some observations:

1) Energy prices traditionally are by far the most volatile component of the CPI, and this past year was no exception. Ex-energy and ex-food & energy measures of inflation were lower overall than the total and much less volatile, which means a lot of the inflation we experienced was of energy origin and temporary.

2) Any change in the trend of a measure of growth over time (e.g., inflation, disinflation) should show up first in the 3-mo. annualized numbers and later in the year over year measures. This is exactly the pattern we have seen with the recent surge in inflation which began in January 2021, when year over year inflation was 1.4%, 6-mo was 2.9%, and 3-mo. was 2.9%. We haven't come full circle yet, but we're getting pretty close, since the 3-mo. annualized measures of inflation (total, core and ex-energy) are now in the range of 1.8% to 3.5%.

Check out these posts from last year, which show I was way ahead of the crowd in seeing the peak in inflation pressures. Moreover, I have consistently argued that the Fed did not need to crush the economy in order to bring inflation down and that is even more true today.

Fed tightening need not result in a recession (June)
Market to Fed: no need to panic (July)
Inflation pressures cool, economic outlook improves (August)
M2 says the Fed doesn't need to crush the economy (August)
More predictors of lower inflation (September)
Fed's Rx for the economy should be a tincture of time (October)
Higher interest rates have solved the inflation pr... (December)

As for the Fed, I would hope they realize that inflation pressures were worse in the first half of last year at a time when the economy suffered two quarters of negative growth (inflation adjusted), while inflation declined significantly in the second half of last year, when the economy enjoyed two quarters of roughly 3% growth (inflation adjusted). This, of course, runs completely contrary to Phillips Curve thinking, which holds that just the opposite is true: namely, that a weaker economy is a prerequisite for reducing inflation.

Moral: the Fed doesn’t need to crush the economy to bring inflation down. Why? Because inflation is caused by too much money, not too much growth. M2 growth started slowing early last year, and the Fed raised interest rates in an unprecedented fashion; that combination worked to bring inflation down because it reduced the excess supply of money and at the same time gave the public a strong incentive to hold on to their unusually large money balances instead of spending them (which would have aggravated inflation pressures). From a broader perspective, stronger economies almost always go hand in hand with low inflation, while chronically weak economies (e.g., Argentina) suffer from persistently high inflation.

There is every reason to think that inflation will continue to cool without the need for further Fed rate hikes. And contrary to what so many pundits are fond of saying these days, the unemployment rate needn’t have to rise in order for inflation to fall. Inflation has been falling quite nicely, thank you, even as the unemployment rate has fallen to historically low levels.

And don’t overlook the unique fact that, despite the Fed’s aggressive monetary “tightening,” credit and swap spreads have been declining for the past three months. If “tight” money were a problem, we should have seen credit spreads widen. But they haven’t. Why? Because higher interest rates are not necessarily bad for the economy, at least to the degree we have seen this past year. What’s so bad about 4-5% interest rates? I’m so old I remember when it was heresy to predict that 10-yr Treasury yields would decline to 7%. And at the time the economy was doing just fine.

“Tight” money came to have that moniker not because the Fed drove interest rates higher, but because in order to push rates higher the Fed had to drain reserves from the banking system. That made money scarce, and that was why monetary policy came to be known as “tight.” The Fed restricted liquidity and that caused marginal players to go bankrupt, which eventually slowed the economy and caused the demand for money to skyrocket, which in turn brought inflation down, but at a huge cost.

Everything changed in late 2008, because that was when the Fed decided to pay interest on bank reserves and simultaneously adopted a policy of abundant reserves (aka Quantitative Easing). Money today is not scarce, bankruptcies are not exploding, yet inflation is coming down. Why? Because higher interest rates have served to balance the demand and the supply of money, and when that happens, inflation declines. Money in the bank pays 4% or so today, and that’s a lot more attractive than the 0% you could earn on money balances a year ago.

That, in a nutshell, is why inflation is down and the economy is still OK. Chairman Powell, are you listening?

UPDATE, Jan.14: I have access to my charts again, so I want to post just this one to illustrate the above text:

Chart #1

Chart #1 compares the 6-mo. annualized growth rate of the CPI (blue) and the ex-energy version of the CPI (red). This highlights the degree of volatility that energy contributes to the CPI. But it also highlights just how much the upward momentum of both measures has reversed definitively. The 3-mo. annualized growth of the ex-energy CPI has fallen to 3.5%, which all but ensures that the 6-mo. annualized measure will continue to decline. The 6-mo. growth rate of headline CPI is already back to levels that preceded Covid on a 6-month basis: 1.9%.

It's true that the year over year growth of CPI is still way above the Fed's target (i.e., 6.4% vs. 2%), but that ignores the much more important changes on the margin. If an MBA teaches you anything it is that you must always focus on the changes that are happening on the margin, not what has happened over the past year. On the margin, the housing market is definitely turning down. Yet about one-third of the CPI is based on the government's calculation of what homeowners would be paying if they were renting the house they own, and that is a very lagging indicator—as much as a year behind the reality of today's housing prices. We know for a fact that housing prices are turning down all over the country, so homeowner's rent will soon be subtracting significantly from the CPI.