Persistent inflation and a faster reduction in QE

Inflation is an economic variable that shows particularly high serial correlation. This is the tendency of past values to be predictive of future values of inflation. In other words, inflationary trends tend not be ‘transitory’, but rather engrained especially when measured by core inflation (excluding more volatile prices of energy and food). This relationship is depicted in the graph on the right.

Using the Cleveland Fed’s inflation projection for 4Q21, the regression would suggest core inflation runs at about 4% over the next 12 months. The simple model tends to be pretty accurate at inflation at today’s levels (the residuals produced are small) but, if core inflation were to rise above 5% the relationship becomes more non-linear. That is to say, that the tipping point for inflation expectations to become de-anchored appears to be a core inflation rates of about 5%.

Larry Summers’ OpEd in the Washington Post on 15 November seemed prescient when he called for the Fed to signal that real interest rates should not fall further. Three days later, NY Fed President John Williams endorsed that view saying “you wouldn’t want those long-run inflation expectations to move significantly further up”. Fed Vice Chair Clarida, Governor Waller and St Louis President Bullard have all signalled in the past week that a faster reduction in QE may be warranted. In doing so, the Fed may have put a floor under real interest rates: further increases in market-implied inflation may warrant at least a verbal intervention from policymakers. All else-equal, that increases near-term risks for equities given asymmetric risks to the discount rate. Historically, there is about a 3 month lag between changes in real interest rates and the performance of equities: something to be especially mindful of in the months ahead given current equity durations (multiples) are elevated.

Source: St Louis Fed. Inflation last year = trailing 12 month median change in prices, excluding food and energy