Perspectives
January 16, 2025 | By Michael Lucas
Policy Issues
Economy

December CPI, Rates & Yield Curves

It seems almost impossible that after the greatest level of inflation in 100 years, with the FED printing $6 trillion and increasing the money supply by 40%, that the worst has already come to pass. But maybe we'll get lucky this time.

CPI Registers Price Increases

CPI figures for the month of December were released on Wednesday, January 15th. The two main versions of the BLS's price inflation index––Core CPI and CPI: All Items––registered an increase in nominal consumer prices on a year-over-year basis. However, headlines reported a decrease in so-called "inflation".

For example, CNBC reported that "Core inflation rates slows to 3.2%." Reuters said "US inflation still slowing as producer prices rise below expectations in December." And Yahoo Finance said "Core CPI rises less than forecast as inflation pressures ease slightly in December."

To the layperson, words and phrases like "slows," "below expectations" and "pressures ease" give the impression that nominal consumer prices are falling. As I've written in previous posts, reported "decreases" in price inflation are not reporting decreases in the sticker price of consumer goods––they are decreases in the rate of price increases.

In November, Core CPI registered at 3.30% while CPI: All Items rang-in at 2.73%. This month, these measures recorded price inflation at 3.248% and 2.896%, respectively. While Core CPI may have "decreased" by 0.052%, these percentages tell you how much higher prices are when compared to the same month in the previous year. A CPI measure of 3.248%, while lower than last month's CPI measure, means that prices in December are still 3.248% higher than they were last December.

As far as consumers are concerned, decreases in the rate of price increases are still good news. But when the decrease is only five hundredths of a percent and price increases are still +3% on a year-over-year basis, it's kind of hard to see the silver lining. Year-over year Core CPI has been above 3% for 43 months in a row and it becomes that much harder to remain optimistic when real wages have been falling since the beginning of 2021, even when using the government's own statistics.

The graph above shows that real wages are still lower than what they were in the first quarter of 2021. A paper by two Heritage Foundation economists––E.J. Antoni and Peter St. Onge––have independently calculated the level of real wages by modifying the weights of the categories used to compute the price index.

Their research shows that real wages are down by much more than what is reported by the BLS. In hourly terms, they estimate that the inflation tax amounts to a decrease of roughly $5/hr, or a 3% drop in real wages since January, '21.

The FED & Interest Rates

Interest rates are another area of significance as of late. Since September, the Federal Reserve has undertaken three rounds of cuts to the Federal Funds Rate after a weak August jobs report and the triggering of the Sahm Rule––a FED tool indicating recession. Now, given the four years of decreasing real wages mentioned above, the United States has already been in recession––albeit a weak one without any sort of financial collapse. But the FED was willing to ignore the fact of recession until more evidence made it abundantly clear to them.

In any case, the three rounds of "rate cuts" have resulted in the Federal Funds Rate falling by 100 basis points, or an absolute 1% point. Shaken by poor labor market conditions, the FED's decision to cut rates is an attempt to "stimulate" the economy by pumping credit (signified by low interest rates) into the market and making it easier for businesses and entrepreneurs to expand and hire new employees.

The only problem with this is that it won't work. It's never worked. And it can't work.

Lowering interest rates necessarily means increasing the quantity of money (inflation) and driving up prices even more. With more credit available to markets at a lower price (interest rate), borrowers are able to purchase resources they otherwise wouldn't have been able to attain at the higher interest rates. Since many of those resources are currently being employed by other businesses, these borrowers bid up their prices, translating to higher prices for consumers.

The continual and rapid increases in prices for the last four years is the inevitable and lasting result of the FED's decision to cut interest rates and keep them at almost 0% for two years in a row. The graph above shows that from March 2020 to March 2022 the Federal Funds Rate remained at this incredibly low level––a sign that the massive Biden-era deficits and stimulus checks were not only financed by the FED's creation of more than $6 trillion, but that they also tried desperately to pump this new money into the banking sector to prop-up business and boost employment.

It is that policy which created the price inflation, the way-out-of-proportion stock values, the commercial real estate bubble and the fiscal disaster currently faced by the U.S. government. Yet the FED is trying to do more of that very same thing.

Too bad for them (and more so for us), markets can't take anymore and a full-blown recession appears to be on the way.

The Yield Curve & Recession

Apart from Sahm Rules, job growth figures and negative real GDP statistics, the inverted yield curve is the best predictor of recession available to us. The yield curve is a graph that takes the yield on the 10-year treasury and subtracts from it the yield on the 3-month treasury. If that difference is negative then the yield curve is said to be "inverted" because it is less than zero. The significance of this is that the inversion of this curve has predicted every recession going back to 1960.

Under normal conditions, you expect the yield on the long-term treasury to be greater than the yield on the short-term treasury: intuitively, if your money is locked-up for a longer period of time, you'd demand a higher yield. Occasionally, however, short-term yields become higher than long-term yields and the yield curve "inverts." An inversion occurs when the FED stops expanding the money supply and creating new credit. This is reflected by rising interest rates.

When the FED creates money in the form of new credit, the increase in credit lowers short-term interest rates (or yields, in the case of treasuries). But, when new credit is no longer being introduced to the market to keep short-term rates low, short-term yields begin to rise and can rise to levels greater than that of long-term yields. In the case of "inversion," short-term yields can exceed that of long-term yields because markets expect future inflation to decrease. Because of this expectation, long-term yields do not need to be as high to offset the inflation, and so remain relatively stable.

The chart above shows the inverse relationship between the Federal Funds Rate the FED targets and the yield curve. When the FFR (blue line) is low the Yield Curve (red line) is high, and vice versa. As you can see, the yield curve most recently inverted in October, 2022 and remained inverted until late November, 2024––two months after the FED began cutting interest rates.

The most important thing to recognize with yield curve inversions is that recessions tend to occur 12-18 months after the initial inversion. Given the real wage data from the previous section, this has already come true. However, the 2022-24 inversion is almost unprecedented: not since the 1970s and 80s has there been such a deep and long-lasting inversion of the yield curve, and the recessions in those two decades were without a doubt the worst recessions in recent memory.

The current situation seems to be rather mild as far as recessions go, but nevertheless signal a multi-year period of stagflation that is impoverishing ordinary Americans.

With the yield curve's recent and sustained dis-inversion (short-term rates and yields now being lower than long-term) on September 12th, one can't help but wonder if a reckoning is coming. 

Will the commercial real estate chickens come home to roost? Will the German or Chinese economies' troubles have a ripple effect on the U.S. economy? Will the public debt have reached its limit?

It seems almost impossible that after the greatest level of inflation in 100 years, with the FED printing $6 trillion and increasing the money supply by 40%, that the worst has already come to pass. But maybe we'll get lucky this time.

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