The inflation trade ‘is collapsing,’ macro strategist says

MKM Partners Chief Economist and Macro Strategist Michael Darda joins Yahoo Finance Live to discuss PPI and CPI data, inflation expectations, Fed policy, monetary conditions, and the outlook for economic growth.

Video Transcript

BRIAN CHEUNG: Again, we were just talking about the PPI and just kind of the inflationary story. To Akiko's question, do you see any signs in the PPI and the CPI, despite the strong headline number, of perhaps a better story on inflation for July, August, maybe later on?

MICHAEL DARDA: Thanks for having me on, and I do. I'd like to pick up on a point that you two just made. The data is somewhat backward-looking. That's actually a critical point. The reason markets are worried is because the Fed now is very focused on headline inflation, even though it's backward-looking. Fed Chair Powell recently said, this is not a time for a lot of nuances about headline in core.

And so the concern is that with high headline inflation potentially weakening economic growth momentum in a very aggressive Fed on rate hikes, a lot of concerns about the business cycle rolling over and an eventual recession are out there. So that's hitting markets hard. But let's look at the front edge of the inflation trade. It is collapsing. The dollar is up 15% year to date. Copper is down more than 30%. Broadly, metals are down almost 30%.

Forward-looking bond market inflation expectations-- and this is good news-- are down sharply, well over 100 basis points. So that's actually helping the Fed tighten. If the Fed is lifting the nominal policy rate against the backdrop of falling long-term inflation expectations, then the real policy rate deflated by expected inflation is moving up quite rapidly.

And so we have tightening monetary and financial conditions that will help to bring inflation down. It will also slow growth. So we're going to have those recession concerns that are lingering, but I think that really is a critical point. The data is backward-looking. We're going to get some better news on headline inflation in the back half.

AKIKO FUJITA: So, Michael, let's talk about what we have seen over the last few weeks, which doesn't necessarily-- is not necessarily reflected in the data. We're talking about commodity prices coming down. Obviously, energy has been a big, big part of the spike we've seen in inflation. We're looking at some food costs coming down as well. I mean, how do you look at that data right now in the context of the bigger picture? And what does that tell us about where we are, whether, in fact, we're close to the peak?

MICHAEL DARDA: Yeah, I think we are very close to the peak. I mean, this very well may have been it this past month. And in my view, I mean, I was quite worried about inflation and quite worried about the Fed being behind the curve. I mean, the last few times I was on the show, we talked a lot about that. But we change our view when the facts change. And if we look at these sensitive forward-looking indicators, they're telling us that the Fed is rapidly catching up, that monetary conditions are tightening.

Growth will slow. Nominal demand growth will slow with a lag. And inflation will slow with a double lag. It is a lagging indicator. But on the headline inflation, I think we're going to get some better news very soon because of these falling energy and food prices now. Very important, with the strong dollar, inflation expectations coming down.

That's actually a very good story, that the Fed's medicine is starting to work. Now, we can talk about recession risks. But the first step in terms of dealing with an inflation overshoot and being behind the curve is catching up. And they're effectively doing that now.

BRIAN CHEUNG: How about the risk of the recession being induced by too rapid of a Fed tightening when you consider markets kind of pricing in that the Fed is more likely than not to do that one percentage point rate increase at the end of this month? You have Chris Waller, the Fed governor, the most significant member so far, saying he still expects 75 basis points, but it depends on incoming data. Retail sales and housing going to be the key there. You think that's the right stance?

MICHAEL DARDA: Yeah, I think certainly the business cycle risks rise when the Fed is moving rapidly to catch up. It's why you don't want to fall behind the curve, to begin with, because catching up means that there's a greater risk of going too far, and then having a recessionary outcome. But that's where we are. I think it would be better if the Fed were more focused on some sensitive forward-looking indicators, like those bond market inflation expectations from the TIPS market that's telling us that what they're doing is working, they're getting traction.

And so, we don't necessarily need panicky rate rises way beyond what the market expects from here. If they do, do 75 or 100, I think there's probably going to be a strong case for slowing it down or even pausing after that. Policy does work with a lag. In the forward-looking sensitive market, they're telling us the conditions are tightening pretty sharply here.

So it's a bit of a dicey situation I would note this. Parts of the yield curve are inverting now. That's creating consternation. The T-bill yield is still below the rest of the coupon curve. But it really is narrowing pretty rapidly. So that will be something to watch for if the Fed goes 75 or 100. We'll probably have a pretty flat T-bill, the coupon curve. If that goes inverted, then I think the recessionary risks are pretty dramatically amplified.