Ben Emons, the founder and CIO of Fed Watch Advisor, is a bond market veteran and lifelong Fedwatcher. He whas held management and advisory roles in financial institutions including PIMCO, Intellctus Partners, and Medley Global Advisors , covering the policy path of several Fed chairs and what it means for the markets.
As Kevin Warsh takes over as Fed chief now and gets ready to chair his first meeting of the policy making Federal Open Market Committee, the big question now is how high inflation will go as the Iran War continues to push energy prices higher and they in turn feed into a broader array of prices. And how restrictive will Fed policy will have to get in response?
Ben’s analysis of the latest consumer price report takes issue with a view that inflation may have peaked because energy prices are off their highs. “But if you look in the report itself, and what I typically do is I don’t go to the first page, I go to page 11 or 16. It shows the year-on-year change of the categories in the CPI index, and I’ve kept a bit track of it. And I noticed that categories <that> are up more than 10% now number 27. You know the number of categories <that> up more than 4% are 71…And, of course, energy is really exploding. Now … notice that in the CPI report it’s going up to close to 50%. That’s been over the last three months.”
He expects the Fed to keep policy on hold now as officials debate but ultimately may have to hike rates to avoid having to slam the brakes hard on inflation with agressive rate hikes in order to bring down inflation as they did in the Covid years. “So I am in a camp of buying a contract on the rate hike sometime in the next, say, 1 to 3 months.”
Ben surprises me when he says Chair Warsh may propose a different policy step to move the Fed toward a more restrictive stance now without raising rates - by starting to reduce the balance sheet.
‘That’s his really strategy in terms of getting the Fed out of the fiscal game and out of the game of the markets, too. He’s been very strong on that, and I think he’ll have some buy in,” he says. “It’s a tool in the box to have policy get into somewhat tighter modes as we go from here. Right. And it’s a more passive way of doing it instead of going blindly for rate hikes immediately. So it creates a compromise between him and others in the FOMC….’
So dive in and hear why Ben also sees the latest jobs report opening the door to a more restrictive Fed policy next week. And why he sees whiffs of hyper inflation potential in the air.
”Hyperinflation is …about a psychology of consumers who are starting to behave, to be ahead of inflation. They are feeling being behind the curve on inflation. So they get that paycheck and they start spending it faster. They start moving, going to the store quicker to get goods that they need.”
”We’re not at this point… we’re not in any hyperinflation environment,” he says, but the window through which the Fed’s credibility to control inflation is viewed may be narrowing.
There is lots of excess inflation across categories, some is quite high 00:01:24:01
There’s a market expectation that inflation may have peaked now because I guess people looking at energy price over the last month, see that they have started to decline -- just look at crude prices. But if you look in the report itself, and what I typically do is I don’t go to the first page, I go to page 11 or 16. It shows the year-on-year change of the categories in the CPI index, and I’ve kept a bit track of it. And I noticed that categories <that> are up more than 10% now number 27. You know the number of categories <that> up more than 4% are 71. And it’s been steadily increasing. Even some categories are up like 20%. And, of course, energy is really exploding. Now … notice that in the CPI report it’s going up to close to 50%. That’s been over the last three months. So underneath this, this it looks like a little softer sort of headline than we had today. This is a lot of price pressures building in a variety of categories , not just food.
Various pressures - 00:02:44:10
Yeah. So obviously there’s a there’s a range of food categories that are, you know, clearly contributing, unsurprising, I guess, some energy. But there’s also medical, there’s insurance. There’s sort of like educational services, childcare services, things like that that are you know, I’ve been going up for a while but have gotten like increasingly the number of, items getting, you know, higher than 5%, say the CPI index is really becoming alarming.
It’s like, you know if it’s like 27% of the index currently, you know, if we’re going to say towards 30% or 40% of the index, we are really actually dealing with a very different inflation environment. And that’s not really in the market pricing today. The graph in the note today shows a presumptive peak expected by markets. But that’s maybe wrong. It could be that could actually be that could actually be higher that big.
Market-makers’ inflation expectations/ bets 00:03:55:01
There are a few ways our markets treat inflation. There’s of course inflation linked market the tips market. And then there’s inflation swaps. But then there’s new contracts that are out that are where people can buy CPI contract. That’s on the release of the CPI report every month. And those numbers are really more accurately reflecting the actual expectation that CPI could be for the next one, two, three, four, five months.
Will inflation history repeat? 00:04:22:06
Those show that peak around four and a quarter (4.25%) that we got today at the number. And then it steadily starts to decline. And it looks like that’s what happened in 2022 too. We hit 9% and then we started to slide down. But if we actually will repeat 2022 is to be seen. Like I said, if there’s so many of these underlying categories going up in price and consistently going up in price, you could question that peak, I think.
Fed likely on hold 00:05:32:08
I am more in a camp of that the Fed will be on hold. I think there’s a consensus view that’s just for this meeting. But the signs that we’re getting the signals better, that we’re getting from various of members are really pointing to that. They do not want to repeat what happened in 2021 or 2022. They want to stay ahead of the curve, right?
FOMC does not want a repeat of 2021 of inflation slipping away 00:05:54:02
They want to make sure that they’re not having this price pressure slip away from them, and then they can’t control it anymore. Right? Or they have to slam the brakes so hard that we’re going to have to jack up the interest rates back to five or higher percent. So I am in the camp that that it’s possible to potentially likely that the Fed will move to a rate increase.
Expectations shift on Fed Communications 00:06:16:16
But there’s an expectations strategy here too. And that’s maybe typical. And you signal a lot of this rate hike, you know sort of messaging. Then the market will obviously follow that messaging. And that’s what’s happened. Right. We’ve gotten away from rate cuts to say a little bit more than one half times rate hikes by next year.
Rates no longer restrictive 00:06:41:06
It’s not dramatic change but it’s the first step to come back combat. I think this inflation proceeding today, which is the energy shock and fertilizer shock into food prices, which spill obviously over into services and core goods as well, you would have to have at least more restrictive policy. So at 3.5%, call it even fed funds rate, where the inflation rate is right now, we’re no longer restricted forever below the rate of inflation.
Expect market to price in more of a hike 00:07:11:14
That’s an issue. So I do think that fed wants to remove that situation and say we have to go back to restrictive policy to make sure we don’t fall behind the curve. So I am in a camp of buying a contract on the rate hike sometime in the next, say, 1 to 3 months.
Different ways to get restrictive policy- Balance sheet? 00:08:39:03
So I think there’s different ways to get to restrictive policy. And I think the way Kevin Warsh wants to get to is, to say, I want this balance sheet to continue to shrink, right. That’s his really strategy in terms of getting the Fed out of the fiscal game and out of the game of the markets, too. He’s been very strong on that, and I think he’ll have some buy in. It’s a tool in the box to have policy get into somewhat more tighter modes as we go from here. Right. And it’s a more passive way of doing it instead of going blindly for rate hikes immediately. So it creates a compromise between him and others in the FOMC like Waller, who was, as you say, previously, a dove and has completely flipped back to really being alert about inflation.
Look for some sort of action – it’s a new game 00:09:30:06
And he’ll be alert about this report. By the way, I think he would not be happy with this report and say like, you know, we need to start thinking about this rate hike, that the balance sheet strategy is something that they would now pursue, as in, let it roll out. They stopped doing that, right.
In search of a compromise path- or not? 00:09:47:10
They face that out to restart quantitative tightening as an initial announcement. He may actually say something about that next week as a starting point, which gives him the compromise towards the administration, which he’s trying to build a better relationship with than what we’ve had previously as an understanding of like we’re dealing with a price shock clearly in the CPI report that can deny us, but we have other ways of dealing with this. And just bluntly, hiking rates. I think that’s where Kevin Morse is coming from. It’s just the money that’s in the system gets, you know, drained from the system, that that’s what that actually means. You know, that is a finite amount of money flowing around and central bank of she controls that. And by changing its balance sheet which sounds like very like accounting entity, it actually does…<something>..
Draining out reserves has impact 00:11:11:05
But in practical terms the banks will have less money on their balance sheet accessible to them. And that makes the monthly policy in itself tighter, because if you think of it, you get all this money sloshing around in the financial system. The money ends up in, in financial markets, but it also ends up in the real economy.
Fed will be forced to tighten 00:13:17:23
Kevin Warsh will likely say something about resuming quantitative tightening at an at next week’s meeting. It’s for him, as I mentioned, a compromise. I think most of the FOMC members will say that that is, at least for now, a comparable solution. But it’s not the solution. Eventually, if inflation continues to go up month-by-month by month, they’re going to have to do something different, which is ultimately tightening policy.
Labor market is no longer weak 00:14:20:14
Yeah, I think what that signal was that we cut rates because of the labor market weakness that we saw in 2024 into 25, and now it looks like that that insurance policy has actually worked, that with all the AI investment that’s happening, which, you know, is generating a lot of economic growth, that combined with that cutting of interest rates at that time, has actually helped the labor market recover from its major slump. And therefore, this insurance policy could be removed. And that will be another way of signaling to say we’re hiking rates by not, you know, having to look at the labor market this point, but addressing price stability will really doing is just taking back of some of the insurance we initially put in there, in fact, put in new insurance to make sure that price stability is guaranteed because, as Powell said, I thought it was a really good quote.
There has to be a shift to seek price stability 00:15:18:20
If the economy doesn’t work, if we don’t have stable prices, it doesn’t work for anyone. If inflation is out of control, no one can function properly, whereas inflation is higher or in deflation it would be the other way. Right? So, price stability I think is for them the message now.
Fed credibility in the balance 00:16:16:07
We’ve had a few instances where markets were getting a little doubt about this credibility of the Fed. You know, you’re seeing some gyrations and interest rates and the curve certain moments in time as an observer and a long term observer that like there’s definitely people in the marketplace that are concerned that the fed is eroding.
Inflation is too high and seems sticky 00:16:40:23
It’s incredible and want to position on that, as in believing that interest rates will go significantly higher in that if the Fed does lose its true anchor of credibility. But if you’re looking at the inflation expectations are the way it’s traded in the market. It’s traded as in that inflation will stay above 2% for the next 5 to 10 years, by about a quarter to a half a percent, which is more than we’ve had in the past, but not to such a degree that it is a 3 percent to 4 percent, 5 percent sort of inflation range that the market is expecting, other than really short term, which is what the graphs showed in these inflation swaps. So I think the market is still believing that the Fed has the ability to get inflation ultimately longer term, more under control. But it’s longer term. It’s not something that will happen in the next few months, which is important for the markets in itself. Right. Because if they were say that they do something, with the balance sheet or the interest rate or combined that brings inflation really quickly down, we’ll get a very different economic outcome.
Lethargic pessimism 00:17:50:01
Right. And that that I think is not expected at this moment. Markets do believe that inflation stays higher for the next year, at least until the Fed succeeds.
Is hyperinflation different from heightened inflation expectations? 00:18:25:02
Hyperinflation is also about a psychology of consumers who are starting to behave, to be ahead of inflation. They are feeling being behind the curve on inflation. So they get that paycheck and they start spending it faster. They start moving, going to the store quicker to get goods that they need. In order to avoid that, they have to pay more for those goods, say the following moment they get their next paycheck. That behavior is somewhat happening now. There’s a bit of a bit of a let’s say, spending search has happened, partly because as you think of the tariffs, for example, that was partly because people were front loading ahead of the tariffs, expecting that the price would go up.
Not there…yet 00:19:20:14
So does that behavior, right. And now it’s a short term that somewhat ease off again. And knowing these examples it became like a spiral out of control spiraling situation. So we’re not there yet. But I want to mention actually the two reports of the Boston Fetters put out one last year on inflation expectations that they modeled that it does look that inflation expectations are behaving like the 70s and just recently calculating that the energy shock, you know, maybe longer lasting right, in their models. That idea now we’re not at this point, I don’t make that clear that we’re not in any hyperinflation environment. And it’s unlikely, I think if you think of the bond market rate, sort of price, the still the credibility of the Fed being able to control inflation. But where the window of that is narrowing, I think and this conflict is kind of unique.
The Hormuz closure affects more than just oil 00:20:53:06
Right. We’re having a closure of the Strait of Hormuz that has not only will flow impact across the globe, but also aluminum and helium and fertilizer inputs to a whole range of consumer goods that, you know, is a real, true supply chain change that is yet to play out. Right. So if this conflict continues, at least we could say that they’re going to be more and more items in our CPI basket are going to go up in price above 5 or 10%, and people are going to react to it.
Supply issues will become more acute 00:22:45:07
You know, the pressure will be on the administration more and more that there are limits to how far you can go with this conflict because of the physical limits, like the note I quoted from Jeff Curry from Carlisle. Really interesting. Like we’re hitting potentially critical minimum levels of inventory on energy in our own country and its supply, which is going to be constrained to the economy that’s happening elsewhere, too.
…and so will political considerations 00:23:09:19
But obviously, there’s a political consideration because of the midterm elections and how inflation affects consumer confidence and expectations and polling. So there’s an entrenched expectation. The conflict for all those reasons will end sooner. But as we’re seeing it playing out today it’s mercurial right. We have a president who takes very direct action one way or the other, where I have to say he has been what we call jaw boning, which means you, you know, you make you using certain ways of messaging the central bankers do to, to influence asset prices. What’s the reason is, is that we’ve been able to draw on a lot of reserves? We had China, who has reduced his inputs on energy because they had stockpiled so much, and we still have an energy sector here that has been able to produce a lot of energy that’s been supplied to different parts of the globe, but that’s a stable I call it a stable disequilibrium, right?
Keep an eye on interest rates 00:24:55:06
We’re stable, but we’re not in equilibrium; disequilibrium. And so I told my clients, in order to think of this, we’re going to expect that there’s going to be more risk premium priced into interest rates, particularly because that’s where the nerve center is if we want to control inflation, it’s going to have to go through interest rates, right. Or signals of interest rate hikes. That’s going to lead to contraction financial conditions through the equity market. It would be the other way or combined that we have to account for that in these very bubble issues. High overvalued environment with major IPOs starting on Friday.
Space X 00:25:45:07
Well I mean brief on that that it is a seminal moment for technology that this is not just a space company, it’s actually an AI company. It’s going to be obviously the dates have may be volatile on all the different issues of that. But if you think of space X, the amount of proceeds it’s raising $75 billion will be a huge infusion to the space AI technology. It’s going to change things. You know, he’s a visionary man who really I think goes beyond boundaries. So I, I think it’s for the US economy very important moment actually because as this drives it into our into space exploration and related, I think we’re going to get more boost of the US economy over time and investment that comes in here.
Capital is still pouring in 00:26:31:10
So that’s the other story that’s driving the stable disequilibrium. There’s a lot of money coming in the United States because of these types of innovations. And the only way inventions truly happen is if the capital is available, it seems that the
Ben Emons
FedWatch was originated as a quantitative investing project to improve the filtering of Fed speak for investment strategies.
Ben holds an MBA from the University of Southern California Marshall School of Business and a master’s degree in international finance and monetary economics from the University of Amsterdam. He is a certified financial engineer from Columbia University and a candidate for the CFA and CMT programs, as well as private markets certification at the CFA Institute.
He has extensive experience in fixed-income and derivatives trading, as well as portfolio management. He held sell, buy, and fiduciary roles, specializing in multi-asset fixed-income, equities, private credit, High Yield, structured credit, and special lending. He is a Managing Director and an Investment Advisor Representative at Highline Wealth Partners, and a Managing Director, Fixed Income at Highline Asset Management.
He has managed global and core plus fixed-income strategies and funds and separately managed accounts for central banks, sovereign wealth funds, pensions, insurance companies, and qualified purchasers’ investors.
He is the author of The End of the Risk-Free Rate, The Financial Domino Effect, and Mastering Stocks and Bonds. He advises advisory platforms, wealth management, family offices, and RIAs on Outsourced CIO services and provides insights on interest rate overlays for hedge funds, broker/dealers, proprietary traders, private credit managers and ETF and mutual fund money managers.
He is a frequent guest on CNBC Fast Money, Squawkbox, CNBC Europe, Worldwide Exchange, and CNBC Asia, as well as Bloomberg Surveillance, Bloomberg the China Show, The Close, TD-Schwab Network, CNN, The Street, NYSE ICE TV, Coindesk TV, and Asian networks such as CNA and RTHK Radio.
