Winning Inflation Battle Requires GDI Contraction

On the eve of important Fed Chair comments from Jackson Hole, everyone expects Jerome Powell to convey the need for higher interest rates required to bring inflation down. Most assumed the last 6 months of economic contraction, as measured by GDP, was the start of a recession that would cause lower inflation soon and allow the Fed to slow its pace of rate hikes ahead. This expectation has already been a fundamental factor propelling stocks sharply higher in July and August. The fallacy has been the focus on GDP while ignoring GDI (Gross Domestic Income). GDI and GDP correlate quite well historically, however during an unusual period of labor shortages and demand driven breakage of the global supply chain, forecasters are missing the underlying strength in the economy. Due to full employment, GDI has yet to have a single quarter of contraction. All recessions witness a contraction in GDI and sharply rising unemployment, yet neither have complied thus far.

Another metric all recessions have are sharply rising continued claims for unemployment. Currently such claims remain near record lows that coincide with the expansion phase of past economic cycles. This echoes our earlier reports that verified there has never been two quarters of GDP contraction, such as we have seen, without many months of a rise in continuing claims for unemployment insurance in the rear-view mirror.

We could point to further supporting metrics of an economic expansion that remains healthy, such as near record low loan default rates, strong consumption trends, record new business formations and the slowing but still historically high job openings.  Somewhat surprising is the parabolic rise in bank checking account assets at all income levels. This is not an economy in distress, despite the great anxiety around inflation.

While our arguments above would appear to counter the plethora of economic Bears out there, it also supports the case that more pain is required before the Fed can approach its 2% PCE inflation target. When GDI contracts, it’s likely the economy will be on the verge of some degree of a recession that will finally see an uptick in unemployment. Until then, Fed Chair Powell will need to quell stock investor optimism and strong consumer demand with Hawkish messaging of continued interest rate hikes until the CPI falls much further. With yet another voter inspired stimulus package this week forgiving student loans, our political leaders risk making the Fed’s job harder. Inflation will definitely fall sharply over the next year, but the $1+ trillion in new spending plans passed this month is only good for election votes, while counterproductive for a Fed trying to restrain consumption. Stepping on the gas and the brake at the same time is not helpful when the car is overheating, but in the end, the brakes win and inflation falls.

Readers know we switched from Bearish to Bullish in early June for an expected rally into August to the 4200’s and later the 4300’s basis the SP 500 Index. Although our time and price window was achieved, most of our indicators have not climbed high enough to generate Sell signals. There is still a small window for one more run higher into mid-September. However, we expect a deep correction to manifest with an important low in the late September to late October timeframe. Any break under SP 3950 would signal that the deep dive was underway, even without new highs in the 4300’s. While the Fed’s commentary at Jackson Hole August 26th is widely expected to communicate further Federal Funds rate hikes, our advice would be to declare larger for longer interest rate hikes to break elevated levels of consumption and market optimism. There is still time for stocks to run higher next week and even into mid-September. but it will take months of falling inflation rates into the 4th quarter before investors can trust the inflation fighting skills of our Central Bank.


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