The Good Oil on Inflation (Part 2)
Insight - Interpretation - Implications
[PART 2: INTERPRETATION - from our Insight it gives context to the Implications]
Revamp
Shown below is a refined version of my earlier chart. In this version I have optimized1 the relationship between the annual change in the price of crude oil and the U.S. CPI rate of inflation.
Using my optimized numbers, I also recreated the chart showing the implied price of crude oil (assuming the historic correlation holds) by the current 10-Year Breakeven Inflation rate. This time, I also included examples of what other levels of Breakeven Inflation would imply for the price of oil.
I just thought you’d appreciate the update.
Continuing on from Part 1 …
And now for the INTERPRETATION. Once we have an Insight, we need to place it in context before we can consider the Implications.
The Fed was right the first time
Transitory! Yes, that’s right. I’m stating the unpopular opinion that the current inflationary environment is transitory. Remember, transitory, by definition, is a function of time. Just because it is a slightly longer transitory than the Fed expected and that the quantum of the jump in inflation was so large makes no difference.
The problem with bureaucrats is they have no courage to stand firm against public opinion, which in this instance, indicates a severe lack of understanding of the cause of inflation and therefore how to achieve their “price stability” objective.
Markets are mostly self-regulating. It’s an Economics 101 thing: prices rise → demand drops → new equilibrium is found → over supply → prices fall → new equilibrium is found etc. All the economists at the Fed forget these basics as they try to manage the economic cycles using backward looking data. What they actually do is exacerbate economic cycles. On the bright side, this provides the opportunity to profit (but it’s ultimately detrimental to society)!
Policy tail-chasing
The Fed aims to fight inflation, but they want to focus on “core inflation” and ignore noisy inflation like that which comes from energy (a.k.a. oil) and food. Yet, here we are in a Fed tightening cycle that is attempting to fight oil price inflation! As can be seen in the first chart shown above, inflation is primarily an oil story. In fact, even “sticky” (core) inflation is primarily an oil story, at least in terms of inflation’s cyclical nature.
As the above chart shows, Sticky Inflation is (for the most part) just ordinary inflation, but it lags by about 15 months. That is to say, it is merely a delayed pass-through of costs incurred over the course of a business cycle (if you compare PMI indices [economic activity] with inflation you see a similar correlation & lag in inflation). The chart above also implies that we are currently likely to be at peak core inflation, even before the Fed has really got started.
It is worth noting that, if the Fed is focused on managing Core CPI, then they are chasing inflation that entered the economy between 12 and 18 months earlier. This means that the Fed will systematically be “behind the curve” … and anyone who has been in the market for any length of time knows this is always the case. The funniest part is that the Fed talk about engineering a “soft landing”, but being so far behind the curve, they always end up tightening into an economy that is slowing of its own accord with the result of driving it into the ground!
Boom! BUST!
As said above, the quantum of this inflationary cycle has been significant (read: Yuge!). Couple that with a Fed that is newly resolved with steely determination to bring inflation under control AND their being systematically ~15 months behind the curve, and we have a recipe for the Mother of All Policy Errors right here & now in 2022.
I make light of it now, but I recall the pain of earlier crashes and know that this one will be no better - it may even be worse.
Fortunately for us, there is still a little time to prepare if you haven’t done so already.
Continued in Part 3 …
I optimized on the basis of creating the same average for both data sets in addition to the same level of variance in each time series, since Jan-1998.