Deflation consternation: Could the Fed be raising rates when it should be cutting?

Some key figures in the market are openly speculating deflation could be around the corner.

In recent years, the US economy and markets experienced significant turbulence, perhaps highlighted by the pronounced money printing spree of 2020-21.

This period of financial expansion was followed memorably by a noticeable increase in inflation during 2021-22, peaking at 9.1 per cent in June 2022 and averaging 7.7 per cent over 18 months.

The rise in inflation was not immediate but rather a gradual process, akin to water slowly filling a bucket, until it becomes unmistakably evident.

However, since July 2022, there has been a notable deceleration in inflation rates, which have halved to an average or trend rate of 3.6 per cent over the past 15 months. This reduction has been largely attributed to a high initial rate and diminishing energy costs.

Despite this decline, the inflation rate remains nearly double the US Federal Reserve’s target of 2 per cent, and is accompanied by a robust job market statistics and strong GDP growth (4.9 per cent in the third quarter of 2023).

The question is, could the Fed be raising when it should be ­cutting?

Understandably, the prevailing sentiment among experts is that the challenge of reducing inflation from its peak to current levels has been achieved. Yet, the task of further reducing it to meet the Federal Reserve’s target is expected to be more arduous.

Jerome Powell, chairman of the US Federal Reserve, recently reinforced this viewpoint and expressed uncertainty about whether the current monetary policy tightening was sufficient to achieve the desired inflation rate. Powell emphasised the need for careful monitoring of economic conditions but acknowledged the risk of becoming sanguine about inflation on the back of a couple of months of encouraging data, saying he was “not confident” the Fed had tightened enough.

The ‘‘stickier inflation/soft landing’’ view is understandable given a steadier inflation rate, which is almost double the Federal Reserve’s 2 per cent target, a tight job market and a strong GDP growth rate of 4.9 per cent in the third quarter of 2023.

In November last year, when I wrote in this column about disinflation and no recession for 2023, it was not the consensus view. Noting such a scenario has historically been good for innovative growth stocks, the Magnificent Seven – Amazon, Apple, Alphabet, Microsoft, Meta, Nvidia and Tesla – rallied. However, that ‘‘disinflation without recession’’ narrative has been factored into those major innovative stocks with pricing power, so investors should explore the validity of scenarios that could surprise or disrupt current consensus thinking. That’s where big prices changes are to be found.

A new narrative is emerging and it’s the possibility of deflation and recession as realistic outcomes, contrary to the more commonly anticipated scenario of sustained, albeit lower, inflation and a soft landing. As an aside, a soft landing would be likely to sustain elevated interest rates, which isn’t great for equities. Better is a short and shallow recession that spurs central banks to lower rates.

Despite the strong US GDP and jobs market, Britain’s Macro Strategy believes the assumption of sticky inflation and a soft economic landing in the US does not stand up to scrutiny.

Looking at GDP, they note that excluding the US budget deficit, private sector GDP “has basically been flat for a year, even in nominal terms”. Meanwhile, indicators including LEIs, PMIs, the yield curve, GDI, tax revenues, corporate profits, money supply, savings rate, intermodal rail, and home affordability appear to be in recession already.

It is critical to distinguish between disinflation and deflation. Disinflation refers to a slowdown in the inflation rate, whereas deflation implies a sustained decrease in the overall price level of goods and services, leading to various economic ­challenges.

Deflation can prompt consumers and investors to delay spending in anticipation of further price drops, slowing economic activity. Moreover, it increases the real debt burden, increasing the challenge of loan repayments.

Cathie Wood of Ark Invest also predicts deflation and a hard landing. Wood recently emphasised declining US petrol prices as reflective of a broad destruction of demand, and said the strong US dollar was a deflationary force. At the same time, weaknesses in the housing and automotive sectors point to a challenging economic landscape ahead.

Predicting macroeconomics is a tough job and arguably unrewarding because the market’s reaction to it is equally unpredictable. But because deflation is not widely accepted today, it is worth watching for any notable experts who hitch their wagons to it. Even if deflation doesn’t emerge, it will impact share prices if fear of it becomes the consensus narrative. Understanding the prevailing economic narrative and its alternatives is crucial in preparing for and navigating potential market surprises.

Roger Montgomery is founder and chief investment officer at Montgomery Investment Management.