Based on ECRI’s research on the U.S. Future Inflation Gauge (USFIG), the Fed should have started a rate cut cycle last September.
This is because, when the Fed started rate cut cycles as soon as the USFIG signaled inflation cycle downturns, we’ve had soft landings, like in the mid-1980s and mid-1990s. But when their rate cut cycles lagged those inflation cycle downturn signals, the economy has gone into recession, like in 1990, 2001 and 2007.
This time around, the inflation cycle downturn signal came last September, so it looks like the Fed is nine months late already (see page 16 of Probing Powell’s Patience).
We shall see. Maybe this time it’s different, and a recession won’t follow. But our leading indexes of the business cycle will tell us either way.
Of course, if the Fed does cut rates next week, their problem will be to justify it in terms of their standard metrics, since they're now backed into a corner where a cut could spook the markets.
Notably, the Fed and the bond market have both been way behind the curve in recognizing this inflation cycle downturn. And the plunge in the market’s inflation expectations tells you that’s the key reason yields have plummeted.
It’s really a lack of understanding of the inflation cycle that was behind the Fed’s earlier abrupt about-face, as well as the plunge in bond yields.
Our USFIG was far more prescient. It leads inflation cycle turning points and, in fact, also leads inflation expectations. The USFIG turned down in early 2018, and by last summer it was clear to us that a fresh inflation cycle downturn was at hand.
Certainly, that inflation cycle downturn wasn’t obvious to the Fed, which hiked rates in September and December.
And the bond market was also caught flat-footed, with market inflation expectations – the spread between 10-year treasury yields and 10-year TIPS yields – remaining high through late fall. Those inflated inflation expectations made bond market “royalty” pound the table about a bond bear market as treasury yields pushed near 3¼%. And remember, at the time, prominent Wall Street houses were also predicting four rate hikes in 2019. ECRI took the other side back then, based on the USFIG, saying that the Fed’s planned 2019 rate hikes weren’t going to happen.
On heels of the subsequent December rate hike, we said on this show: “We have our inflation cycle downturn call. The Fed is going to get there whether they like it or not – they are going to become more dovish.”
Looking forward to talking Fed & inflation on @TradingNation today. Flashback to Dec 2018 @CNBCClosingBell on heels of Fed hike: "...we have our inflation cycle downturn call. The Fed is going to get there whether they like it or not. They are going to become more dovish." pic.twitter.com/ESJF2TxeXv— Lakshman Achuthan (@businesscycle) June 7, 2019
Last week the USFIG plunged further, meaning that the U.S. inflation cycle – a concept that most economists, including those at the Fed, don’t seem to understand – will stay in a downturn.
We’re talking about the direction of the inflation cycle. Any which way you measure it, overall inflation has been falling since last July. And that downturn isn’t over.
Sure, economic growth looks okay at the moment. But coincident economic indicators tell you nothing about recession risk. Nobody remembers that the latest real-time GDP print, right before we entered the Great Recession, was 4.9%.
The point is that, while a recession may not be imminent right now, there’s still real recession risk. And – remembering the long and variable lags with which monetary policy impacts the economy – you don’t want to do what the Fed did ahead of the last two recessions, when they started cutting rates just a couple of months before those recessions began. It was too late.
* * *