The Risk of a Recession is Still High
The risk of the Fed causing a recession is still high, even though today's stock market rally makes it seem like that risk is lower. One month of lower-than-expected CPI figures won't be enough to make the Fed change its plans.
While the stock market may have rallied in response to the lower-than-expected CPI number for October, this does not necessarily mean that it is a good sign for investors. In fact, interpreting it as such could be dangerous. The reality is that it is premature to say whether or not this number means that the Fed's restrictive monetary policies are working to bring down inflation. Until we have more data, it is best to remain cautious and not make any rash decisions based on this one number.
I believe that the stock market rally on the news of lower-than-expected inflation numbers is not likely to last, as it was likely caused by computerized trading rather than a fundamental change in investor sentiment.
The Fed's difficult task of calibrating monetary policy so precisely has caused months of market fretting that it has been too forceful in tightening conditions. If data now shows that inflation is declining, the market reasons that the Fed will loosen its grip and spare the economy from too much pain.
I welcome the news that inflation is running at 2% but it doesn't change my views one bit. I still believe that the bigger risk is from tightening too little. This is echoed by San Francisco Fed chief Mary Daly who said that one month does not make a victory. The focus should be on bringing inflation back to 2% reliably. I don't see anything in the incoming information that has changed the look of that path.
The Fed's obstinate stance on inflation may be just what the economy needs. Given how the Fed looks at inflation, their determination to keep prices in check may be just what is needed to help the economy grow.
It's good news that inflation is down, but it's worth noting that this is largely due to falling prices for goods. This could be due to improved supply chains, but it's also possible that it reflects weak demand. Either way, it's something to keep an eye on in the months ahead.
It's good that cheaper stuff is available, but most people still spend more on services than on goods. Unfortunately, services inflation remains very high, and has actually been rising in recent months. This means that people's overall costs are still going up, even if the price of goods has fallen.
It is clear that inflation expectations can have a significant impact on economic activity, and that services inflation can play a key role in this. The wage-price spiral is a key factor in this, as it can lead to a self-reinforcing cycle of higher prices and wages. This can be difficult to combat once it starts, so it is important to be aware of the risks of inflationary pressures building up.
The stability of relative prices is important for businesses and consumers alike. When relative prices are disrupted, it can lead to confusion and uncertainty. This can ultimately lead to higher prices and inflation.
A large, sudden and permanent change in the price of one input can trigger an overall price escalation, simply because those who provide the items that have not gone up have lost purchasing power relative to the ones that have. This can cause inflationary pressures to build up in the economy, eventually leading to higher prices for goods and services.
There is a lot of debate among economists about the role of relative pricing in inflation. Some economists think that relative prices are not a factor in inflation at all, while others think that the fight to restore relative prices to their pre-pandemic levels is leading to the expectation that inflation will continue to rise. The U.S. economy has certainly seen a large change in relative pricing since the pandemic and a large increase in general inflation, so perhaps the disruption of relative pricing is more important than doubters maintain. If so, the Fed is correct at fearing the entrenchment of inflationary expectations.
The Fed's commitment to bring inflation down is admirable, but the risk of a recession as a result of their policy is still very elevated. Stock prices have not fully incorporated this risk, and investors should continue to tread carefully.