Inflation: 'The Fed is increasingly behind the curve,' analyst says

MKM Partners Chief Economist Michael Darda joins Yahoo Finance’s Brian Sozzi & Julie Hyman to discuss the costly rise of inflation and what it means for the future.

Video Transcript

BRIAN SOZZI: Well, let's stay on inflation and what it can mean to your investment portfolio. Michael Darda is MKM Partners chief economist and macrostrategist and joins us now. Michael, always nice to see you. Putting this question to all strategists that come on the show today, how could one invest successfully in a land of, really, inflation that is not going anywhere any time soon?

MICHAEL DARDA: It's a great question, and thanks for having me on. So quite a bit of uncertainty and confusion out there at the moment. All of that said, you know, we have a stock market that's been on an absolute tear despite high inflation. That's not always been the case historically, but it has this time around and, I think, for a set of very specific reasons.

One is that market interest rates are still extremely low on a historical basis, even though, you know, they're up year-to-date from where they were in January, essentially range bound from the first quarter. Liquidity levels are high, and companies have a lot of pricing power, so profits have been very strong despite those high inflation readings.

That doesn't necessarily mean the market is going to continue to soar on a go-forward basis. I think it's really going to come down to the future path of market interest rates and how the Fed maneuvers moving forward, because they will be moving into a tightening cycle probably before many forecasters assumed that they would.

JULIE HYMAN: Mike, it's Julie here. When would that be? Because it sounds like from your recent notes that you think the Feds are already behind the curve here. And, I guess, that also feeds into the discussion that we've continually been having as to, if they're behind and they start to raise rates, how much will that actually help to curb inflation?

MICHAEL DARDA: Right, so really important topic. I do think the Fed is increasingly falling behind the curve. One way to think about that is the inflation adjusted policy rate. And we can even forget some of the statistics that have been elevated with the headline in core CPI and just look at market inflation expectations. At the five-year horizon, we're up above 300 basis points now, pretty much a record level since that market goes back to the late 1990s.

And so as inflation expectations have picked up, the inflation adjusted policy rate on a forward-looking basis is actually falling. And this is happening not with deteriorating macro fundamentals, but improving labor market prospects of plunging unemployment rate, first-time jobless claims falling to a succession of post-pandemic lows. So by sitting still, the Federal Reserve is actually passively easing monetary policy.

And keep in mind that the taper does not mean tightening. It doesn't mean asset sales. The Fed is still adding to its balance sheet every month and is expected to continue adding to its balance sheet through the middle of next year. So this is really an unprecedented, accommodative monetary policy on the part of the Federal Reserve. And for that reason, I think an expectation that these inflationary pressures are just going to sort of disappear on their own, which seems to be what most of my competitors are saying. I'm afraid, it's highly unlikely.

BRIAN SOZZI: Well, if those pressures are unlikely to dissipate, Michael, and it sounds like we could see a series of rate hikes next year, no?

MICHAEL DARDA: No doubt about it. So if we look at futures markets, they are already pricing in several rate hikes starting next year, and then additional rate hikes moving into 2023. But what's interesting about this market pricing is those expectations have simply moved with inflation expectations moving higher and credit risk spreads moving lower.

So there's really no actual tightening going on. A tightening means the Federal Reserve is getting in front of the neutral rate curve, and as a consequence, slowing the economy more towards potential growth. That is not on the horizon any time soon. So, you know, we had this big debate about peak growth, and peak inflation, and peak profits. And, you know, it got a little bit silly a few months back.

But the key is, if growth is running well above trend, well above the growth rate of potential, then we're going to have pressure on prices and costs, especially as the capacity side of the economy is constrained. And we can see that with the unemployment rate and a host of other indicators that are moving much more forcefully than they did in the last cycle.

JULIE HYMAN: So Mike, put it together for us and talk about what happens to stocks, then, if we start to see the Fed get more aggressive next year.

MICHAEL DARDA: I mean, I think, it probably means we're going to see a pickup in market volatility. It could also mean a reorientation into stocks that have lower equity market multiples, what we would think of as value. Depending on how the dollar performs, I mean, that'll have implications for overseas markets versus the US.

One thing it doesn't mean, at least initially, is that the economy will suddenly plunge into recession. I saw some quite bizarre commentary on Twitter recently, you know, essentially making the argument that the Fed shouldn't be hiking rates and tanking the economy because of supply side shocks. I mean, who's talking about tanking the economy? What we're talking about here is the Fed moving because the neutral interest rate is moving up. And if they don't, then you have overheating and inflation. And that really complicates the Fed's adjustment process later on.

So, at least initially, as the Fed moves towards stopping the growth of the balance sheet and raising short-term interest rates, there's not going to be any kind of a recessionary risk. That will come later if the Fed ends up tightening too much or if they wait so long that they really have to play catch up. You know, it's going to be harder to slow the vehicle at high rates of speed, if you will. And so I think that's what we need to focus on here.

JULIE HYMAN: Bizarre comments on Twitter-- imagine that. Mike, does your scenario change if Lael Brainard becomes head of the Fed?

MICHAEL DARDA: You know, maybe a little bit at the margin. But honestly, I don't think it would be a radical departure from the Powell-led Fed. They're both on the same page in terms of the Fed's average inflation, you know, targeting regime now. And so I think at the margin, the answer is yes. But it really is marginal.

If we look at how markets reacted to that speculation last week when she went to the White House for a supposed interview, real rates dropped, inflation expectations moved up. But this had already been going on before that speculation. And so I think it's really a matter of degree. And it's probably pretty modest.

BRIAN SOZZI: Michael Darda, MKM Partners chief economist and macrostrategist, we'll see you on Twitter. Have a great rest of the week.