Inflation cycles are complex, with many interconnected parts. Price changes flow unevenly through the distribution and production channels, lifting final product prices. For example, consumer price inflation doubled from 4.2% to 8.3% in the past year. Yet, that surge is directly linked to even more significant price increases for thousands of items in various processing stages. Indeed, producer prices for crude goods rose 48% over the same period, intermediate materials by 22%, and finished producer products by 16%.
Consequently, taming or reversing the inflation cycle is not as simply slowing or ending the price increases for consumer goods and services. Instead, it requires a broad price reversal across various products and services, impacting production, distribution, and retailing businesses. And that "unwind" process is destabilizing and uneven, resulting in liquidity and cash flow squeezes and profit and income declines.
The Fed's immediate goal is to bring consumer price inflation back to a 2% rate. Although there are many paths to a 2% inflation rate, the most common, based on recent experience, is a sharp slowing in consumer commodities (goods) prices, which accounts for 40% of the overall CPI.
CPI commodities (goods) prices have increased by 13% in the past year. Not surprising, these retail prices are nearly perfectly correlated (86%) with producer prices for intermediate materials, which have increased by 22% over the same period (see chart). Moreover, the correlation is robust, even removing the volatility from food and energy, with core consumer commodities rising 9.7% in the past year compared to a near 17% increase in core intermediate prices.
A few episodes have occurred, none recently, in which intermediate materials and consumer commodities prices dropped from double-digit increases to near zero. Fueled by restrictive monetary, prices of producer materials and consumer goods fell hard and fast in the mid-70s and early 80s. Both periods, heavily influenced by supply-side shocks, resulted in economic downturns that ran for sixteen months, nearly a half year longer than the average recession of the post-war period.
So it is not surprising to hear Fed policymakers say, "it will be challenging, not easy," to bring inflation back to 2% from 8% without triggering a recession. That's because it t's never been done. And very easy to see why.
For a broad set of industries and businesses, equaling nearly half of the economy, there would be a "flash" crash in prices. On average, price increases would drop from annual gains of 10% to 20% in a year to zero. Yet, given the unevenness of price cycles, many firms would even experience price declines. Sharp price reversals would trigger an abrupt drop in revenues and profits, forcing cutbacks in output and labor.
The unwinding of price cycles creates many losers because the Fed is negatively impacting the flow of commerce and finance through its restrictive policy moves. So far, the losers are in finance-- bonds, equities, and crypto, along with increased volatility. However, investors should expect much more since the Fed tightening cycle, which has just begun, needs to crack the many links of the inflation cycle.