David Gitlitz has been predicting for some time now that the economy will stay robust and that inflation’s still a problem. The bond market may be forecasting recession and falling inflation, but that’s a bet that will be proven wrong, says the chief economist for TrendMacrolytics.
A few weeks back, Gitlitz’s view looked mistaken. In late September, the yield on the 10-year Treasury dropped to under 4.6%–the lowest since February. With Fed funds at 5.25%, a 4.6% 10-year yield created an inverted yield curve in no uncertain terms. Recession, in other words, was coming, the fixed-income set predicted, and inflation was winding down.
But in the wake of yesterday’s report on consumer prices for September, investors are again wondering if inflation is still a threat. Yes, top-line CPI fell 0.5% last month, and the yield curve’s still inverted. But the 10-year’s yield has been rising of late, and so is core inflation. In fact, core CPI advanced 2.9% for the year through September–the highest in nearly a decade.
With the latest inflation report hot off the government’s press, we thought it was a timely moment to chat with Gitlitz and get the details on his latest thinking. What follows is an edited transcript of our phone conversation from late-yesterday afternoon.
Q: What’s your take on the consumer price report for September? The top-line measure of CPI fell, but CPI ex-food and energy advanced by 2.9% for the year through last month, the fastest pace since 1996.
A: The suggestion that somehow…there’s nothing to worry about [regarding inflation] is off the mark.
A: Because a 2.9% annual core inflation rate…can hardly be considered benign. The top end of the Fed’s comfort zone [for core inflation] is 2.0%.
Q: We’re way above the Fed’s comfort zone.
A: That’s right. I think it’s likely to get worse before it gets better.
A: Because the price pressures that are embedded in the system, as a result of the Fed being as easy as it’s been for as long as it’s been, are feeding through. Within the next year there’s a very good chance that we’ll be running something like a 3.5% core. And that’s just based on what the Fed’s already done. There’s basically nothing they can do to reverse that. The only thing they can do is get to an equilibrium posture so that they don’t continue to make it worse. And from everything we monitor, they’re still not [at equilibrium]. So we think the Fed will be raising rates.
Q: You’ve been saying for some time that you think the bond market’s been underestimating the future strength of the economy.
A: Yes. Bond yields are now running on the order of 25 basis points above where they bottomed out a few weeks ago. At that point the bond market was discounting two or more Fed rate cuts over the next year. Now they’ve cut that down to one or more. But I think even that’s still going to end up being the wrong bet. Not only is the Fed not going to cut rates, I think it’ll go back to hiking rates again sometime within the next several months.
Q: Where do you see Fed funds topping out in the current cycle?
A: Probably at something like 6%, maybe even higher, depending on how bad the data gets.
Q: To revisit a point you made, you’re convinced that a future of higher core inflation is virtually a done deal. The Fed can’t change that future because it’s a byproduct of its “easy” monetary policy of recent years. Monetary policy, in other words, takes a long time to play out, and the monetary chickens are now coming home to roost.
A: Monetary policy works with long lags. Once it’s there, once the Fed puts in the kind of inflationary impulses that’s already embedded in the system, it’s there. All you can do is wait for it to feed through the system and get to a point where you’re not continuing to feed additional impulses into the system.
Q: How concerned are you that the housing market will continue to soften and perhaps trigger a recession?
A: I’m not concerned about that at all. I think it’s a non-issue. The bond market’s bet that housing was going to be a disaster that pulled down the rest of the economy. But that’s not happening. And, frankly, I thought it was the wrong bet right from the start.
Q: Even though the yield curve is inverted? Traditionally, that’s a sign that a recession is coming. What does the inverted yield curve say to you?
A: It says that there’s a bond market bet that the economy’s going to crater, and so the Fed’s going to have to cut rates. But that isn’t going to happen. We’re going to see a steepening of the yield curve in the next several months.
Q: If the economy’s growing and continues to remain strong, that makes it easier for the Fed to raise rates.
A: Yes. In the Fed’s model, if the economy’s growing more than they expect, they regard that as an inflation risk, and that adds to the pressure to raise rates again.
Q: On the other hand, if the economy weakens, the Fed will be in a bigger bind because it’ll be tougher to raise rates under those conditions.
A: If the economy turns out to be weaker at the same time that inflation continues rising, that puts the Fed in a tough spot. Eventually, they’re going to have to choose inflation as the problem to deal with. When push comes to shove, there’s no way out for central banks on that issue. But I don’t really think that’s the way it’s going to play out; I don’t think the economy’s going to weaken much going into the fourth quarter and into next year.
Q: What are the signs that support your prediction?
A: Well, there are very few signs that don’t support it. Consumption is strong, investment is strong. I look carefully at indications of risk preference in the system. When you have signs that investors are willing to bear risk, it suggests that they see a pretty positive growth outlook. If they weren’t positive on growth, they wouldn’t be putting capital at risk, especially in high-risk instruments like junk bonds. All those signs tell me that growth expectations remain solid. When growth expectations are solid, it becomes a self-fulfilling prophecy because people do things to realize those expectations. They put capital at risk to reap the available return. That’s what creates growth. All those things tell me that the economy is chugging along nicely.
Yes, you get a number here and there that’s a little soft. But that doesn’t tell me there’s anything to worry about. We had an industrial production number earlier this week that was a little soft. But if you look beyond the headlines for that data, there’s a lot of good stuff going on within the world of industrial production. The technology sector’s growing at a very rapid pace. That’s part and parcel of the risk-preference notion that when you see that kind of activity strengthening it means that people are putting capital at risk…and you have to have pretty good expected returns to justify the investment. That tells me that the basic foundations of this economy remain very healthy.
Q: So, in your view, there’s no recession on the horizon.
A: The chance of a recession is nil based on what we see with current conditions and current indicators.