CYCLICAL INFLATION AND THE "POWELL PIVOT"
Over the last week, the Fed has guided interest rate expectations higher. Much has been made of the “Powell Pivot,” but it has actually been a long time coming. Two months ago, we noted that one reason for a more hawkish Fed could be tied to measures of personal consumption expenditure (PCE) inflation published by the San Francisco Fed. These measures attribute core PCE inflation to cyclical and acyclical components. Acyclical inflation is less sensitive to monetary policy and tends to rise and fall based upon the idiosyncratic characteristics of the individual components. Healthcare is one example. Cyclical components are more sensitive to monetary policy and the business cycle.
Early in the pandemic we faced a deflationary period. That changed in April when inflation first began accelerating. This initial wave of inflation was dismissed by the Fed as temporary and due to supply chain and other pandemic-related issues. In an earlier Brim Shot post, we said that the Fed’s reluctance to reduce stimulus might be tied to the indication that most of the rise in inflation was acyclical. In fact, from January through July of this year, an average of 72% of the monthly inflation numbers was from acyclical components, and only 28% from cyclical. This attribution implied that tighter monetary policy might have little effect on inflation, though it could stifle the economic recovery, leading to stagflation.
But the Fed started sounding more hawkish in September. Why? One reason might have been that cyclical core PCE began rising faster than the acyclical components. That trend has since continued and accelerated. In fact, the attribution has now reversed from the earlier period. From August – October this year, cyclical components accounted for a monthly average of 65% of inflation vs. 35% for acyclical. Not only is inflation accelerating, but the component that is more easily controlled by monetary policy has become its primary mover.
Meanwhile, long-term inflation expectations, measured by break-even rates and consumer surveys, continue to be fairly well-contained. So at this point, the Fed may be able to raise rates to contain inflation but still keep the economic expansion going. While the Fed looks at many indicators, the shift from acyclical to cyclical inflation may still be a large part of the “Powell Pivot” to a more hawkish stance.
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