Timeframe & Expectations (Looking at M2, Fed Fund Changes and Sticky Inflation)

In the battle with inflation, the Fed always wins. The war either goes smoothly and victory is quick and decisive or it’s a slog with a lot of collateral damage. There were early hopes in the current battle against inflation that influences would prove to be transitory, and the victory would be quick and decisive. As the months have dragged on and inflationary prints continued to roll in hotter than expected, the hopes of a quick victory have been dashed, and a slog towards victory has begun. Ultimately, in the modern era, the Fed has never conceded until Fed Funds is above CPI. With Fed Funds at 1.75% and CPI at 9.10%, that’s quite a gap to cross. Although the abyss is intimidating, we have to keep in mind that the Fed has laid out a path for Fed Funds to 4.00% by the end of the year and inflation looks poised to begin marching lower as well, so the hope will be that they meet in the middle. The overarching questions then becomes, when and what will the collateral damage be?

To address the first question of when, I’d like to be optimistic here, but if history is any guide, a battle against high inflation is not something that is won quickly. The main tools to fight inflation are controlling interest rates and liquidity. One way to measure liquidity is to measure M2. When the Fed first embarked on Quantitative Easing (QE) in 2008, for the next twelve years M2 grew at an average annual pace of about 6%, which was in line with nominal GDP. Since March of 2020, M2 growth has average about 17%, about three times the average over the previous decade. M2 is currently contracting at a rate of -3.8%, so we’re on pace to bring M2 more in line with potential GDP in the coming year but getting there will be a process. There is a reasonably tight relationship between M2 growth and inflation, but with a significant lag, indicating that maximum effect on inflation has historically been 12 to 18 months after the move in M2. There is a similar pattern between the Fed Funds rate and CPI. When we look at the percent change in Fed Funds versus CPI, we find that there is a similar 12 to 18 month lag before interest rate hikes really begin to take a bite out of inflation.

Another way to try and gauge how long inflation will be with us is to look at the Atlanta Fed Sticky CPI Index, which sorts the components of CPI into either Flexible or Sticky categories based on the historical frequency of price adjustments, and then recalculates CPI on each basket. The Atlanta Fed Sticky CPI Index increased at an annual pace of 8.1% in June. The total percent of items in Core CPI that are considered “Sticky” is 70.1%, with an average adjustment period of 10.7 months, as compared to the “Flexible” basket, which represent 29.9% of CPI, where prices adjusted in an average of 2.5 months.

Putting these three measures together, we see that M2 and Fed Funds generally have operated with a 12 to 18 month lag. The Atlanta Fed Sticky CPI have historically had a price adjustment period of about 11 months. Although we are open to the notion that this time may be different, it would seem realistic to expect that the impact of current policy on inflation will really start to show up in mid-2023. That’s not to say there won’t be progress before then, and ultimately, it’s progress that we need to see for the Fed to reduce pressure, which will set a floor under the financial markets, but overarching message is that the process will take time.

CONCLUSIONS

The Fed will win the battle with inflation. We’re all anxious to see this happen so we can get on with our lives and begin investing again in a policy environment balanced by full employment and price stability, but it will take time to get there. While we’re on the path to a balanced policy environment, asset prices will be pressured, but as long as the three-legged stool of earnings, jobs and Balance Sheets hold in place, and the rapid rise in rates does not trigger an asset crisis, we believe selloffs will be orderly and the bottom from our current range may relatively shallow