With $31 trillion in public debt outstanding the Fed can’t quickly take interest rates to where they need to be (north of 8% CPI), to tame inflation. The interest expense on the public debt would be punitive at that level (Debt to GDP is 123%, up from 31% during our last inflationary period of the late 1970s and early 1980s).
The Fed however can tame inflation by tightening monetary policy sufficiently to knock the economy into a deep recession. A deep recession will cripple consumer demand and knock the CPI down to 3-4% over the next 2-3 years. As the cost of credit continues to move higher, asset values (homes, automobiles, equities, retirement portfolios), are moving lower. As consumer net worth continues to decline, consumption will decline – especially for discretionary goods and services, thereby causing prices for goods and services to decline.
If we go back to 1980, 2-Year Treasury yields moved above the CPI prior to a recessionary period (see first chart below). The one exception was the COVID lockdown-driven recession where CPI remained above the 2-Year yield (see second chart).
The Fed can’t go to a 6%, 7% or 8% Fed Funds Rate for an extended period of time to help thwart inflation, but it could take the Fed Funds Rate to 4-5%. A Fed Funds Rate slightly north of 4% for all of 2023 seems reasonable. In such a scenario the 2-Year Treasury yield would likely sit around 5%, a level the 2-Year has not seen since June 2007.
Our view is that the CPI will not see 2% again this decade.
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