Fed Funds – Inflation Differentials: Strange History
We revisit the historical differentials of fed funds vs. PCE and CPI that are only now reverting to pre-crisis relationships.
We look across the cycles at the relationship of fed funds and inflation metrics as fed funds returns to the status of “positive real fed funds.”
Something had to give after inflation was running well ahead of fed funds during 2021-2022 since technically, negative fed funds still amounted to accommodation.
The result to date in 2023 is lower inflation and materially higher fed funds with the potential for more hikes to come.
With the monthly release of Personal Income and Outlays and the PCE Price Index data yesterday (see Good (Mixed) News: Sub-4% PCE Wins 6-30-23), we included some commentary on the historical relationship of fed funds to inflation metrics. We refer you to that piece but follow up in this note with the details and histories of the relationship.
Modern capital markets had very few data points across the cycles to use as a frame of reference outside of the Volcker inflation fighting years and during the bouts of stagflation during the 1970s. As noted in the chart above, we see how Volcker got the job done with fed funds running well ahead of PCE during the main parts of the battle in late 1979 to late 1982 when the double dip recession then gave way to the bull market 1980s. The pattern of “fed funds > PCE” in the chart is clear. The brief exception came during those periods where the Fed let fed funds float in a wide range as the Fed aggressively targeted monetary aggregates.
After Volcker passed the baton to Greenspan in 1987, the painful memories of inflation and stagflation were still fresh in minds. The positive real fed funds differentials thus stayed in place. The hair trigger was evident after any remote hints of inflation after 1986. Many see the year 1986 as the “VI Day” for Volcker’s Victory over inflation with 1% handle PCE and 1% handle CPI. The easing gave way to one of the wildest debt underwriting cycles of 1987-1988 and the last one within the framework of Glass-Steagall.
Those 1% handle PCE and CPI metrics in 1986 coincided with the collapse of oil prices, regional economy carnage in the oil patch, and waves of regional bank and thrift stress. That put the “inflation win” on the list of Pyrrhic victories in many ways, but history shows that is a big win for the legendary Volcker. It also left open the question of how the Fed in later years would treat the “transitory” nature of commodity costs – notably oil – in future inflation battles such as the one that popped up in the 1990 Iraq invasion of Kuwait.
During the late 1980s, Fed decision makers were hard wired to tighten on any hint of inflation. Similarly, many of the later FOMC members cut their academic teeth in those years, and many (clearly not all) still carry some of those lessons on policy. Prior to the credit crisis, the priority of real fed funds and fighting inflation was a given reality. Then the crisis and ZIRP years came after 2007. That is when the fed funds vs. PCE relationship flipped.
We did not see this topic get that much press earlier in the tightening cycle of 2022, and we were somewhat surprised that it did not get more play in the strategy debates (see Fed Funds vs. PCE Price Index: What is Normal? 10-31-22). We saw some from the buyside on the issue, but the history was not a hot topic in Powell commentaries. Presumably, that sort of history lesson (“we need positive fed funds”) would have freaked out markets as well as the White House and Congress and set off a brutal dynamic of public commentary.
We have finally arrived closer to that fed funds destination for headline and core PCE and headline CPI. We are a near miss on Core CPI vs. the fed funds upper target of 5.25%. The question is whether sticky Services inflation in a services economy will send the Fed back to the Volcker playbook in mild form. That was on the table in the latest FOMC releases.
A look back at the timeline of the differentials (fed funds minus PCE) …
The above chart runs through the timeline of “fed funds – PCE differentials” from 1972 through current times. We use the daily effective fed funds numbers (or averages as noted) and end with the 5.25% upper target as of Friday as a frame of reference. We provide a long-term median on the fed funds – PCE differential and break out some notable time horizon medians as noted in the box. We highlight the positive long term and pre-crisis medians. We also flag the negative post-crisis median numbers. We would argue the pre-crisis numbers apply today.
The obvious change in the relationship was the credit crisis of 2008 and later the pandemic as the priority shifted to the employment part of the Fed’s dual mandate. During the credit crisis and aftermath, inflation was not the main event. Jobs ruled. The backdrop was also about keeping more banks from collapsing and providing some protection against a severe credit contraction that would choke off growth and rehiring.
For the pandemic, the return to ZIRP and QE ran alongside a raft of backstopping initiatives to make refinancing and extension in the markets possible all along the credit spectrum. The actions also provided a lot of support to household discretionary cash flow on mortgage refinancing and lower monthly payments.
As we look at the medians above and the bigger picture around employment and the major banks, the median differentials of the pre-crisis years are more relevant. The relationship is below the pre-crisis median at this point as noted in the box. In other words, the “hawkish pause” (see FOMC: Hit Squad or Suicide Squad 6-14-23) and threats of more hikes is consistent with history.
The above chart does the same drill as what we did for the fed funds – PCE differentials. The CPI is usually (not always) higher than PCE across history as we have looked at in past commentaries. We will update that relationship another time. The long-term median of CPI vs. PCE differential has been less than 1 point over time, and the deviations are usually around oil price spikes and how those flow through the numbers. As we said back in an October write-up on CPI vs. PCE:
“…the two track very closely with some brief periods of differentials moving higher. It ends up like the Miller Lite commercials of the 1970s of “Tastes great or less filling.” If it is the only beer being served, you drink it anyway. CPI has the advantage of being served first each month. The BLS data is also more filling.”
The Fed lives by its 2% target for headline PCE, and the FOMC is staring at sticky Services inflation and record payroll counts. With May JOLTS data dead ahead on Thursday and June employment data on Friday, the FOMC and the markets will get a fresh batch of inputs.
The recent data flows have been more positive of late, and the equity markets have been rolling in 1H23. The question is “Will good news start to be bad news again?” The rates question is alive and well. The recession will take longer to form and needs some very bad news to get there. That is harder to come by now that we have gotten past the debt ceiling binary risk event, inflation cut in half from June 2022, housing in better shape, and record high payrolls supporting autos. We can always see some market risk repricing, but economic contraction is no small order for the bears right now.
See also:
Fed Funds, CPI, and the Stairway to Where? 10-20-22