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The Misery Index Is Rising. What That Says About Rates.

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Federal Reserve Chairman Jerome Powell at his confirmation hearing this week.
Brendan Smialowski/AFP/Bloomberg

Now, in the winter of our discontent, it shouldn’t be surprising that the Misery Index has made a comeback. Those of a certain age will recall it was a measure conceived in the 1960s by the economist Arthur Okun, then an adviser to President Lyndon Johnson; it added unemployment to inflation. That sum would describe the economic woes faced by most of us whose concerns might be more banal than the difficulty of finding a slip big enough for a new megayacht. Except for the 0.1%, having a job and being able to pay the bills ranks higher on the worry list.

During the post-World War II era, the Misery Index ranged from a low just under three in July 1953, when inflation was negligible and the U.S. was fully employed, to about 22 in June 1980 at the height of the stagflation under President Jimmy Carter. The Misery Index was in a steady ascent last year, pushing into double digits in April and standing at 10.9 by December. Not surprisingly, as misery increased, the University of Michigan’s consumer sentiment index started to roll over.

The last time the Misery Index got into the double digits was in May 2012, when it was 10.4, with unemployment at 8.1% during the slow recovery from the recession following the 2007-09 financial crisis. But inflation was subdued then, at 2.3%, as it had been for most of the past quarter-century.

That is, until last year. The misery index rose and consumer sentiment fell despite a steady decline in the jobless rate, to 3.9% in December. Inflation has proved more intransigent than transitory, the term that Federal Reserve officials optimistically used, and that has spelled misery for those having to pay higher prices.

And so inflation moved to the evening news and front pages of newspapers this past week, with the consumer price index rising 7% in December from a year earlier, the biggest year-over-year increase in four decades. The blame gets pinned on the much-publicized kinks in supply chains as the Covid-19 pandemic persisted.

But Joseph Carson, the former chief economist of AllianceBernstein, who has consistently sounded the claxon about inflation, finds that easy money boosted reported inflation as much as supply shortages and bottlenecks.

He assumes supply constraints accounted for all of the jumps in prices of new and used vehicles, rental cars, household furnishings and appliances, apparel, sporting goods, and food consumed away from home. All told, he figures, those items accounted for about 3.5 percentage points of the 7% rise in the CPI.

While the news stories trumpeted that this was the biggest yearly rise in the CPI in almost four decades, Carson points out that the jump would have been much larger if the index was calculated with the formula used before 1982, which counted house prices to estimate homeowners’ housing costs. House prices were up 19% from a year earlier, according to the most recent S&P Core Logic Case-Shiller Composite index. Imputed rent–a measure in CPI that estimates what homeowners would be willing to pay to rent their homes–was up only 3.8%. Adjusting the homeowners’ costs for actual prices would have added an additional 3.5 percentage points to the reported 7% rise in the CPI.

Easy money contributed to this actual surge in inflation while the pandemic pumped up other prices, Carson contends. Somehow we doubt there are houses or condos on those container ships anchored off the West Coast that would ease a tight housing market.

What’s also different from the last time inflation ran this hot is the federal-funds rate, which Jim Reid, head of thematic research at Deutsche Bank , observed was at 13% in 1982. With the Fed now continuing to peg its key policy rate at 0% to 0.25%, the real rate (after adjusting for inflation) is below anything seen during the Great Inflation of 1970s and only comparable to the World War II era, he wrote in a client note. Deeply negative real rates equate to super-easy money.

At his confirmation hearing before the Senate Banking Committee this past week, Federal Reserve Chairman Jerome Powell reiterated the central bank’s intention to keep the current high inflation from getting embedded in the economy.

But when asked by Sen. Pat Toomey (R., Penn.) how realistic was it to bring back inflation to the Fed’s targets while maintaining negative real interest rates, Powell’s initial response was to blame disruptions causing supply to trail demand. He added that if the Fed sees inflation persist, it will use its tools and raise rates.

Meanwhile, the Fed’s policy remains very expansionary in the face of the inflation that’s making us miserable. While most of that has been in soaring prices of goods, higher service costs may become the greater problem, especially as lagging rents start to feed into the CPI.

The consensus among top Fed officials and market participants now is that liftoff for the fed-funds rate will take place at the March 15-16 Federal Open Market Committee meeting with a 25-basis-point hike being given an 83% probability on Thursday, according to the CME FedWatch site. Odds favor additional 25-basis-point moves in June and September, with a fourth increase in December given better than even-money odds. Four hikes would put the funds rate at a whopping 1% to 1.25%, still negative in real terms. (A basis point is 1/100 of a percentage point.)

While those increases are on the horizon, the Fed is continuing to purchase $40 billion of Treasury securities and $20 billion of agency mortgage-backed securities each month. Although the FOMC announced a further tapering of its bond buying at its December meeting, it is continuing to add liquidity by expanding its balance sheet, which is closing in on $9 trillion, up from about $4 trillion before the pandemic.

The latest inflation data should spur the Fed to announce an end to its securities purchases at the Jan. 25-26 meeting, Neil Dutta, head of economics at Renaissance Macro Research, writes in an email. While the asset purchases are supposed to end by March, paving the way for the much-anticipated first lift in rates, he said an earlier end would be a very small, hawkish surprise to the markets expecting an eventual runoff in the balance sheet.

Dutta sees low odds of getting inflation down into the 2% zone by year end, as envisaged by the FOMC’s latest Summary of Economic Projections. “There is quite a bit of inflation in the pipeline,” he says. Aggregate incomes are growing at roughly 10%, he estimates. So, unless one assumes real growth of 8%, it’s hard to envision a 2% inflation rate, he adds.

To rein in inflation, the Fed’s monetary expansion will have to slow and eventually reverse. As the central bank stops buying and starts redeeming maturing securities, J.P. Morgan estimates the market will have to absorb an additional $350 billion in bonds this year. Slower growth in the money supply will leave less excess cash available to be plowed into equities, according to a report by Nikolaos Panigirtzoglou, head of the bank’s global quantitative and derivatives strategy group.

This prospect of tighter liquidity already is making for a miserable start to 2022. It may be just beginning.

Write to Randall W. Forsyth at randall.forsyth@barrons.com

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