MKM Partners Chief Economist & Macro Strategist Michael Darda joins Yahoo Finance Live to weigh in on September CPI data and how the Federal Reserve may respond.
Video Transcript
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BRAD SMITH: Let's continue this conversation on CPI with MKM Partners Chief Economist and Macro Strategist Michael Darda. Michael, always a pleasure to speak with you and get some of your insights. I just want to get your reaction to the headline figure and the fact that we've seen, still, some of the persistence in inflation nudging higher and showing up in prices.
MICHAEL DARDA: No doubt about it. So I think what really scared the markets here was the strength in the core inflation readings, in particular you mentioned we have rents going up pretty rapidly. This was the largest month-over-month rise in rental inflation since June of 1990.
And we know that the Fed is very focused on these slow-moving stickier parts of the inflation process, a lot of things tied to the service economy, which has been rebounding. And we have to keep in mind that a lot of these numbers tend to follow the business cycle with long and varied lags. So in particular, sticky core inflation measures like rents will tend to follow the economy by five quarters. That means the strength here could simply be a reflection of how the economy was doing 15 months ago.
And that's really what has these market prices in a bit of a squeeze and that's that the Fed is reacting very aggressively to backward-looking information. A lot of the forward-looking measures of inflation have really come down sharply. But the Fed is overlooking that, and they are hitching their policy moves to deeply lagging indicators, and the economy is caught in the crosshairs of that.
JULIE HYMAN: So, Mike, what are those forward-looking indicators that you are taking your cues from when you're saying maybe we're seeing a little bit of positivity coming on the inflation front? And then what you're saying implies that the Fed is indeed making a mistake here.
MICHAEL DARDA: Yeah, I think they are on the cusp of going too far and way too fast. I think there was some justification for them moving aggressively when the rate hikes started. But to persist now with the 75 basis point rate increases with an inverted yield curve and with residential real estate hitting the skids I think is a mistake in strategy.
But in particular, the sensitive forward-looking price level indicators that are moving lower in a dramatic fashion, commodity prices in a big bear market, they ran up dramatically for two years on the front edge of the inflation process, and the Fed ignored it. The dollar has soared in a historic fashion. Bond market inflation expectations, where investors are putting their money on the line, have come down dramatically.
And let's not forget how this whole inflation process started with a huge explosion of the Fed's balance sheet, a big rise in broad money, a lot of expansionary fiscal policy. All of that is going into reverse gear now. And I mentioned residential real estate a moment ago. That's where the V-shaped boom really started in terms of the whole recovery process. So everything that has been on the front edge of the boom in the inflation process has rolled over very sharply, and yet the Fed is acting in an aggressive manner looking in their rear view mirror.
BRIAN SOZZI: Well, then, Michael, how do we get inflation down? I mean, this is the Fed's gig. Their sole purposes there is to, among many other things, full employment and get inflation under control. If they're not out there being aggressive, who does that fall to? Do we have to look at the Biden administration to finally do something?
MICHAEL DARDA: Yeah, this is the Fed's responsibility in terms of inflation, at least the portion of inflation that's due to strong demand, and by our calculations, that's most of it. But the Fed also needs to be forward-looking. If they were forward-looking, they wouldn't have put the monetary stimulus on as long as they did. They would have been sooner to tighten policy. And there would be less of a risk of overshooting on the other side, which is exactly where we are now.
So it would seem to me that they could improve policy by looking forward, by incorporating some of those forward-looking indicators into their process. So they should really be slowing down the pace of hikes now, not reacting in a belated panicky fashion to deeply lagging indicators. That is a prescription for an accident.
JULIE HYMAN: At the same time, Mike, one has to sympathize sort of, right? Like, you see this alarming number, right? And there is the perception that the Fed has to act on this. Of course, you're not the only one with this message.
We are seeing now and hearing from an increasing number of economists who are saying something similar to what you are saying. What would convince the Fed to listen? In the past, we have sometimes seen dramatic things happen in the market that have then convinced the Fed to act perhaps belatedly. How would that kind of a scenario play out?
MICHAEL DARDA: Well, I mean, I think the setup here is we're going to need to see some softness in these lagging indicators, or at least some of the coincident information. Payrolls were very strong in September, so that didn't do the trick. This core inflation data has been strong. And so we're really going to need to see the momentum there break to the downside. I think that is coming.
Give you another fold indicator that was peaking six months ago, the ISM Prices Paid Index. Typically, there's about a six-month lag in terms of when that's showing up in the inflation readings. And so if you go back to six months ago, we were basically at the highs for 2022 there, and now we're off very sharply. So over the next three to six months, I think we're going to get some better news on inflation. That may not be soon enough to save the economy from a recession with the Fed likely to keep going pretty aggressively here in the near term.
And then the discussion right before I came on was about these peak policy rate expectations now are pushing towards 5%. That's well above the rates across the whole Treasury yield curve, which, to me, means if that happens, we will be going into a recession. Inflation will fall very sharply in a recession. And then the Fed will be backtracking and cutting rates in an embarrassing fashion.
BRAD SMITH: Mike, for consumers who wake up this morning and see the headline number, and then also see the market reaction, there's also the reality of how they think about their own spending. Does this change any household spending even knowing just how much we're paying for everything from groceries to some of the other necessities and even some of the discretionary items that we still continue to buy?
MICHAEL DARDA: No doubt about it. I mean, the labor market has been very strong and resilient, so that's sort of been the saving grace. But these-- this inflationary backdrop has certainly been an irritant to households, and we can see that in a lot of weak confidence data. So far, that hasn't been enough to stop the economy in its tracks. But we have the Fed tightening very aggressively, and that will hit the economy with a lag.
Over the last seven months, policy rates have gone up 300 basis points. And in real terms, if we use inflation expectations, which have been falling since March, a 400 basis point rise. That is the most rapid rise in short-term interest rates that we've seen since the early 1980s going into a very deep and very long recession. So I think households, unfortunately here, are also caught in the Fed's crosshairs because the tightening is likely to keep going until it kills the labor market. They'll kill inflation, but they're going to end up killing the labor market with it.
JULIE HYMAN: Woo. All right. Sobering here, Mike. Thank you so much for being here with your analysis. MKM Partners Chief Economist and Macro Strategist Michael Darda.