A Case for Deflationary US Economy Ahead

We often hear about inflation, interest rates, and economic shifts, but what do they really mean for us? Today, we’ll unpack some of the most pressing macroeconomic issues and understand why the Federal Open Market Committee (FOMC) might be shaking things up.

It's easy to get caught up in the headlines, especially when they talk about things like rising oil prices or "chipflation." But the everyday person's understanding of inflation often differs significantly from an economist's. We might see gas prices go up and immediately think, "Inflation!" However, true economic inflation isn't just about a single item's price increasing; it's about whether that price hike spreads across the entire economy. If the cost of oil goes up, does it then cause the price of everything else to rise because businesses pass on those costs? That's the crucial question.

Despite what many might assume, the current economic indicators in the US don't show this widespread "pass-through" effect. He believes that the fear of inflation is often overblown. For prices to truly escalate across the board, consumer demand would need to be almost limitless. Think about it: if rice prices go up, you might buy less rice or switch to bread. If bread prices then also rise, that's a pass-through. But if the economy is weak, people might just cut back on both. This concept of "demand elasticity" is key. Oil, for instance, is often considered elastic; if prices soar, people might drive less or buy an electric car. If the economy is sluggish, they might just stay home. So, while specific prices might fluctuate, the broader inflationary pressure isn't as strong as some believe.

The Trump Tariffs and the Myth of Inflation

Remember when former President Trump introduced tariffs, and everyone worried about them sparking inflation? Tariffs are more likely to lead to deflationary pressures rather than inflationary ones. This might sound counterintuitive, but its backed up with historical data. Looking back at 2016, when tariffs were also a hot topic, inflation didn't materialize; if anything, prices dipped. In fact, throughout US history, numerous tariff events have rarely led to inflation.

When tariffs hit, businesses face a choice: absorb the cost, pass it on to consumers, or see currency exchange rates adjust. The idea that costs will automatically be passed on to consumers assumes infinite demand, which simply isn't the case in a real economy. Many economists and media outlets, often critical of Trump's policies, might be quick to label tariffs as inflationary to fit a narrative. However, look beyond the headlines and consider the broader economic context. The overall demand pressure in the US economy is actually quite weak, making it difficult for businesses to simply pass on increased costs to consumers.

Decoding the Real Economic Signals

So, if headline inflation and tariff concerns aren't the full picture, what should we be looking at? Some key indicators. One of the most telling is the "trimmed mean inflation," a measure that strips out the most extreme price changes to give a clearer picture of underlying inflation. While the more commonly reported "headline inflation" (often shown as yellow lines on charts) might appear to be rising, the trimmed mean inflation (represented by thinner lines) has actually been on a downward trend since late last year. This suggests that price increases in specific items aren't spreading to other goods and services.

This divergence indicates that the US economy is either slowing down or consumer spending power isn't as robust as some believe. If the Federal Reserve (the Fed) bases its monetary policy solely on the headline figures, they might end up tightening too much, only to realize later that the underlying economy was weaker than they thought. This could lead to a sudden policy reversal. While the current quarter might see some continued tightening, by the fourth quarter, as oil prices stabilize and the deflationary pressures highlighted by the trimmed mean become more apparent, the Fed might have to pivot. This shift could be a positive development for the stock market, especially for sectors like AI.

The Fed's New Communication Style: Less Hand-Holding, More Self-Reliance

Now, let's talk about the Fed and its communication. Kevin Warsh, a prominent figure, has suggested reducing the number of FOMC meetings from eight to six per year. This might seem like a small change, but it signals a significant shift in how the Fed interacts with the market. The old Fed to an overprotective parent, constantly giving the market answers and guidance. This "forward guidance," which became prevalent after the 2008 financial crisis, was meant to stabilize a struggling economy. The market has become "spoiled" and overly reliant on the Fed's explicit directions.

Warsh's move to reduce meetings and adopt a less direct communication style is an attempt to foster market maturity. It's like a parent telling their grown child, "You're an adult now; figure things out for yourself." The market, accustomed to hand-holding, initially reacts with uncertainty, leading to increased volatility, especially in long-term bond yields. Short-term yields might fall because the Fed isn't explicitly signaling higher rates, but long-term yields rise due to the increased uncertainty about future policy. However, this might be a necessary, albeit painful, transition. Ultimately, it can lead to a more resilient market with less long-term volatility, as participants learn to interpret economic signals independently rather than waiting for the Fed's pronouncements. After all, central banks, despite their expertise, have often been wrong in their predictions.

Unreliable Employment Data and Future Rate Hikes

When it comes to economic indicators, there are some strong opinion about employment data: don't trust it. There’s a significant discrepancy between two key employment surveys in the US: the establishment survey (which asks businesses about their hiring) and the household survey (which directly surveys households). Historically, these two surveys tend to move in the same direction. However, recently, the establishment survey has shown robust employment growth, while the household survey indicates a worsening trend.

Establishment survey might be overstating employment figures, possibly due to statistical issues or an increase in single-person businesses that are counted differently. Believe in the household survey, which shows a decline, is a more accurate reflection of the true state of the labor market. This divergence is a critical point, as many market participants and the Fed itself rely heavily on employment data to gauge economic health. Despite his personal interpretation, the Fed will likely still raise interest rates at least once more this year. This isn't necessarily because the economic data demands it, but rather due to political pressure and public sentiment. With oil prices rising again and many economists advocating for rate hikes (often in opposition to Trump's policies), the Fed might feel compelled to act, even if its internal analysis suggests otherwise.

Oil, Currencies, and Asset Allocation

Looking ahead the impact of geopolitical events, like the Ukraine war, on oil prices tends to normalize after about seven months. Considering the timing, expect oil market risks to subside around September or October, regardless of ongoing conflicts. With former President Trump potentially eyeing the upcoming midterm elections, there's also a strong incentive for him to push for an end to conflicts, which could further stabilize oil prices. This stabilization would reduce inflationary pressures and potentially lessen the need for further rate hikes by the Fed.

Finally balanced approach for asset allocation. While the semiconductor industry still holds strong long-term prospects, its recent rapid growth might lead to short-term adjustments. For those feeling uneasy about high volatility, we recommend diversifying into assets like bonds or gold. These assets, which haven't seen the same highs as stocks, could offer a psychological buffer and a more stable return profile during periods of market uncertainty. It's about finding a comfortable balance and not putting all your eggs in one basket, especially as the market navigates this new era of less direct guidance from central banks.