Inflation: Is 2022 the New 1980?

Yesterday's CPI report upended a narrative that had taken hold in recent weeks by (ever optimistic) sell-side analysts and strategists (see one prime example here) that inflation had peaked. After headline CPI for April fell to 8.3% year-on-year ("YoY") versus 8.5% in March, many CNBC guests were selling the idea of a soft landing and new bull market in stocks. Not so fast...here's a summary of the May report: 

• YoY headline inflation reached 8.6%---a fresh 40-year high vs 8.3% consensus
• Worse, core CPI (excluding the more volatile food and energy components) was up 6.0% vs 5.9% consensus 
• Goods inflation was just 1.7% of the 8.6%; declining as supply chain disruptions moderate. However, service inflation was up 3.0%---the highest rate in 4 decades. (Click chart below to enlarge)
  
  
  
   Source: Zerohedge

Not surprisingly, the markets did not react well. The S&P 500 and NASDAQ Composite were down 2.9% and 3.5%, respectively, on Friday. The two benchmarks are now down 18.7% and 29.4%, respectively, from their 4Q21 peaks. And for the tech-heavy NASDAQ there are real shades of 2000, as shown below. After 140 trading days, or ~6 calendar months following the peak, the NASDAQ of 2000 and the NASDAQ of 2021 are tracking each other almost to the percentage. As reminder, the NASDAQ eventually lost 80% of value following the dotcom bubble. 

                                                                Source: Yahoo Finance, Mantabye

 

We'll at least inflation is nowhere near as bad as in the 1980s, right? Nominal inflation was after all running over 14% YoY in early 1980. Or was it? Larry Summers, who correctly warned about inflationary pressures last year, is now cautioning that inflation may be worse than what the official numbers show. How's that? In a new paper, Summers and co-authors Marijn Bohuis and Judd Cramer, argue that prior to 1983, the CPI did not correctly account for consumer spending on housing. The authors claim that the way housing spending was measured pre-1983 was "without conceptual foundation...and resulted in a substantial upward bias in the CPI." You see, the pre-1983 index included both home purchase prices and the total outlay of mortgage payments, despite mortgages being paid out gradually over several years." Summers and colleagues argue that "this caused inflation measures before 1983 to look artificially high at the beginning of the tightening cycle, and to recede artificially fast." According to Summers, Bohuis, and Cramer ("SBC"), when the alleged problem with housing spending is removed the official inflation rate of 13.6% in 1980 falls to 9.1%. That's just 50 basis points higher that yesterday's reading. Yikes! 

The upshot is that if SBC's methodology is accurate, it could mean that Federal Reserve will have to get far more aggressive to bring inflation under control, despite recession risks, like Paul Volcker did. For example, SBC estimates that "a return to 2% core CPI inflation today may require nearly the same amount of disinflation as achieved under Chairman Volcker." As reminder, Volcker’s monetary tightening increased the federal funds rate up about 10 percentage points, to a peak of 20% in the early 1980s to bring core CPI down by 5 percentage points. So, by that logic, bringing core CPI down from 6% to 2% may require hiking the feds fund rate by 7-8 percentage points! Good luck with that!