MKM Partners State “Elevated Inflation May Simply Burn Itself Out”

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In a research note Thursday, MKM Partners analyst Michael Darda told investors that elevated inflation may simply “burn itself out.”

“We’ve been writing about the front edge of the inflation trade going into reverse gear with metals off more than 20% from the highs seen this spring and bond market inflation expectations down more than 100 bps from the highs of the year,” said Darda. “High headline inflation (and recent slow growth in the nominal quantity of money) have begun to meaningfully reduce the inflation-adjusted money stock, which peaked more than 21% above the pre-pandemic trend growth path last spring and, as of last month, is now ‘only’ 14% above the pre-pandemic trend growth path.”

The analyst added that if the nominal quantity of money continues to grow slower than trend as the Fed reduces the monetary base and brings short rates up, the process of right-sizing the real money stock will continue. “In this way, the current period of elevated inflation may simply ‘burn itself out,'” he stated.

Darda went on to explain that bond market inflation expectations at the five-year horizon have pulled back more than 100 bps since late March, while the current rate of decline, the broad money stock will be back on its pre-pandemic trend in two years.

Will the Fed be able to eliminate the bulge in the real money stock without a recession? questioned Darda. “At this point, that is an ‘unknown, unknown.’ Most historical periods of a falling money stock (in real or nominal terms) have been associated with recessions. However, every single recession since the mid-1950s was presaged by the 10-year Treasury yield falling below the Treasury bill rate, something that may occur in the future but has not occurred yet,” he explained. “Although the financial press has gone ‘all in’ on the ‘two down GDP quarters’ definition of a recession, that actually IS NOT how a recession is properly defined for the U.S. Instead, a recession is a period of falling production, sales, income and employment that usually lasts more than a few months.”