Tonight we examine how a heavy CPI print may force the Federal Reserve’s hand in raising interest rates – just not as high as the market may think.

"Nothing is as permanent as a temporary government program."  

― Milton Friedman

Tomorrow marks the release of January’s CPI print. The numbers are expected to be very, very hot. 

Over the last year, the country has been forced to listen to the Federal Reserve do their best imitation of a broken record, telling us time and time again why inflation was only transitory. 

We have heard them say it's temporary “due to bottlenecks in the supply chain,” and continually heard them promise that inflation will go away – even as they then deny having anything to do with inflation directly. 

But tomorrow presents the Fed with their biggest challenge in a very long time. 

The ability of the Federal Reserve to continue to deny that inflation is real has long since come and gone. The price of everything has soared, and tomorrow’s CPI numbers will confirm it for all the world to see.

Inflation is raging!

The “lowest” estimates on the street are for inflation to come in at 7%, while the highest predictions are as high as 7.7%, with the median CPI forecast expected to be 7.2%. 

This puts the Federal Reserve in a tight spot.

You can’t have interest rates pinned at 0% while inflation is continually running above 7%. It demolishes the credibility of the central bank, which is why virtually every other central bank around the world has been raising interest rates, and why we are certain to get a minimum 25 basis point hike from the Federal Reserve in March. 

But it puts investors in a tight spot, as well.

Why is inflation such a problem for investors?

Simple. Stocks and bonds have soared because the Fed was ignoring inflation and keeping rates at 0%. As investors have become accustomed to the easy money and the ongoing asset purchases, the everything bubble has inflated further and further. It’s only reasonable to conclude if it was a specific accommodation that caused everything to go higher, then the removal of that accommodation could (and likely would) cause everything to plummet lower. 

Nobel prize-winning economist Milton Friedman explained the trick about inflation four decades ago, back when inflation last raged. 

When he asked people whether inflation hurt them or helped them, most people would say that inflation “absolutely hurt them.” When he pointed out that their houses, their stock and bond portfolios, and their salaries went higher, he learned that what people really wanted was “the prices of the things they buy to go down, but the prices of the things they sell to go up.” And that, according to Friedman, is a “neat trick, but not one that is sustainable.” 

He concluded, “Most people really don’t want inflation to go away. It’s only when inflation becomes a problem that people want to stop it.”

Now, inflation has become a problem – just not for investors. 

What’s happening on Main Street is that prices are rising too fast. It’s becoming politically unfeasible for the Biden administration. As a result, the “non-political (wink wink)” Fed, much to the chagrin of investors, is now being forced to address the problem. 

Biden’s approval ratings are tumbling while the price of gasoline keeps surging. The chart below shows the correlation. As gas prices have continued to rise (white line), Biden’s approval rating (yellow line) has continued to plummet. Biden now has an approval rating below 40%.

But it's not just Biden’s ratings that are dumping. As a result of the impending Fed tightening, the Nasdaq is down over 10% and volatility has become the new normal. 

The biggest concern for investors tomorrow is what happens if CPI comes in above 7.2%. Anything above this number, and the market may expect that the Fed will be forced to raise rates by 50 basis points. These “inflation expectations” could cause a complete downward repricing of financial assets. 

According to Bloomberg, “a hotter-than-expected U.S. inflation print would push the Federal Reserve closer to considering its single largest rate hike in more than two decades. A reading above the projected 7.2% annual advance in prices - which would be the largest since 1982 - may pressure the Fed to consider its first half-percentage point increase since 2000, instead of the typical quarter-point move.” 

We all should remember that it was the Federal Reserve’s surprise 50 basis point move in 2000 that caused the dot-com bubble to collapse. 

What makes all of this even more of a clusterbomb is that, as of this moment, the Fed is still buying bonds. Rick Rieder, Chief Investment Officer of Blackrock, said today that he believes the Fed may need to come out right now and “end their asset purchases immediately.”  

Imagine what an emergency announcement from the Federal Reserve would do to markets after CPI numbers are released if the Fed felt the need to follow Rieder’s advice? This is why investors are so concerned, and why there has been so much volatility in stock and bond markets.

The Federal Reserve must deal with a devil of its own making. 

Friedman explained it simply enough forty years ago: “There can be no mistake, the cause of inflation is a rapid increase in the money supply, and caused by the Federal Reserve.” 

These words are as true today as they were then. 

The Fed expanded their balance sheet from $3.6 trillion to $8.8 trillion in less than two years. This is the most amount of money ever added to the money supply. Not in a specific period of time, but ever. We’ve printed more money than was ever in production over the last two years. 

While there can be no doubt that inflation is raging, nor any doubt about who is the cause of that inflation, we at Brentwood Research have very strong doubts that the Fed will raise rates by a full half a percentage point in March. We find it hard to believe they will be able to raise rates more than twice this year, much less the 6 or 7 times predicted by many investment banks. 

Our reasoning is simple. 

The Fed watches the yield curve. The most important spread on the yield curve is the 2-10 spread. The difference between these two is the amount of rate hikes the Fed can pull off without collapsing the market by causing a yield curve inversion. This spread has been rapidly declining over the past year, signaling that a slowdown in the economy may be coming. 

In March of last year, the spread between 2’s and 10’s was 1.58%. 

Today, the 10-YR treasury closed at 1.951% while the 2-YR Treasury closed at 1.37%. This is a spread of 58 basis points.

The narrowing of this spread makes it nearly impossible for the Fed to consider 50 basis point hikes. That alone would cause the yield curve to invert.

Here’s some food for thought for long-term investors.

We expect gold prices could soar after the coming FOMC meeting in March when the Fed delivers what will be considered a very dovish 25 basis point rate hike in the face of 7% inflation. 

For the last few years, we have been adamant that the Federal Reserve will intentionally and continually remain behind the inflation curve. Our bet is that markets are about to realize how completely stuck the Federal Reserve truly is. If they don’t raise rates accordingly, we will likely see gold soar to new all-time highs. 

Of course, if they do, they could cause another recession. 

Friedman explains the challenge simply enough. “The cure for inflation is simple. Spend less and print less. Of course, doing these things leads to painful side effects. Bonds go lower and inflated stocks devalue. They lead to higher levels of unemployment and a slowdown in the economy, and why the only cure for inflation would be when it becomes politically profitable for the wrong people to do the right thing.”  

We have often suggested that great long-term investors play “chess” rather than “checkers.” 

As the checker players preach rate hikes, we’re analyzing the Fed’s reaction to the market’s reaction and predicting the next 3 moves. 

Inflation? Deflation? Stagflation? 

Regardless of the next economic move, we believe gold is the piece that too few players hold - and every portfolio needs.

Best,

Adam Baratta

Editor-in-Chief

Brentwood Research