With the last few sets of Inflation data coming in over the last few months, it does perhaps look like the worst of the inflation nightmare is behind us … the peak looks to have past. In Fact the last round of data came in at expectation.
But make no mistake … just because the peaks looks to have past, doesn’t mean that the economic picture has suddenly become nice and rosy. Let’s just rip the band-aid off … things aren’t good. The last year-on-year CPI figure (Dec 14’22) came in at +7.1%, up from +6.8% 12 months earlier. That’s still 14.4% in 2 years. Hell, the Month-on-Month number was still +0.1% … inflation is going up … still. 
But as long as the peak number is below the all time peak and the rate is off the high’s … then things are surely getting better? Right?
Well … not so fast!
The Fed … and the rest of the worlds reserve banks might be trying to reign in inflation by heavily culling the demand side of the economy, and it looks like we might be seeing the first signs of things working … but there is a big lag between what the policy makers do and when the effects are seen. Interest rates have been hiked aggressively, and its easy to make the mistake that we should see instant results.
In some places on the personal level we do … in others, we haven’t seen the impact … yet! So, what happens if the levels of inflation suddenly drop? It could only be a good thing, right? Well … maybe not!
The current situation
So, whilst we zoom over the situation from low earth orbit, lets take a look down to take a simple view of what is happening.
Firstly, the cost of Oil has come down … a long way. Just on its own the entire oil and gas market is something close to a sock drawer. But ignoring the geo-political exploration, production, supply and consumption issues and who is involved … gasoline and gas (Crude and Gas Commodity) have gone down , easing pressure on the consumer. Diesel is still up, so industry is still paying a heavy price but the pressure does seem to have ‘eased’ … for now.
Real estate is currently feeling the full force of all the rate hikes. Building approvals are down. Month-on-Month approvals in Australia this week were down 9.0%, the expectation being 0.1%. Someone was asleep there. In the US the figure was 140,000 less than expectation. People aren’t securing loans for new homes, and there are deflationary impacts downstream from there. 
Let’s not forget the renter. When the mortgage goes up, the wannabe home buyer who can’t secure a home, suddenly has to rent. More rent demand … higher rents. Shock Horror! Higher rents, lead to decreased discretionary spending. Less coffee, burgers, shoes, mugs, shirts … follow the bouncing ball!
Inventories are starting to rise, lead times are coming down. 65% of companies about to report earnings are warning the markets to expect a downturn during 2023. The Job market is showing tremendous resilience even as personal savings rates drop to the lowest level in the last … however many years. 
The amount of dollars left over in the house hold budget is running low … the camel is loaded. Which straw is going to the be the one that breaks its back? 
Speed is Everything
So, what happens next? Before we go on … who knows! There are so many Brainiac’s, thought leaders, analysts … bloggers and wannabes with various opinions (see what I did there?), that everyone has to be wrong. Hell, I know I’ve been … I might have got somethings right, but day-to-day … I’ve struck out quite-a-number-of-times. Below was one of the times I kinda got it right
“… flight leader, Operation Bull-Run is go. you’re cleared to start your run, stay in the canyon and watch for reversal at 4,100 … good luck … Tower Out!”‘Crashes, Crypto & Money Disasters’
Any who … speed is everything. Despite the most aggressive rate hiking cycle in a generation, the impacts have been somewhat dulled. Make no mistake, the impacts are there, but the economy has shown remarkable strength.
My guess is this … the household budget is hurting. But the moment the labor market softens and prospective employees no longer have the leverage to demand a higher salary, we’ll see things start to tumble.
When salaries no longer afford luxury items, and employees across multiple sectors start to get laid off, the record low savings will vaporize quickly, and the slide will be well and truly on the way. Governments and Banks were far too easy when it came to easy money and they were far too slow to respond when things started to get out of control.
Now that the holiday spending season is over … I think the conditions for a pop are good.
Related: Crashes, Crypto, & Money Disasters
Fast … QE and corrective cycles
As much as we want interest rates to drop, mortgage stress to ease and make money a bit more affordable … what happens if it does?
Its arguable to say that we haven’t felt the full force of monetary tightening take effect. Major policy decisions don’t take full effect until months after their put into place. A Conditional mortgage offer lasts for 90 days. That’s three rate hikes until you need to get re-assessed. If a loan does get approval, then the time for a property to settle in the order of 3-6 months, puts the mortgage owner on a variable rate 6-9 months down the track before they feel the full force of the banks wrath.
And that’s just a home loan. What about policy?
Current policy is saying that rates wont drop until inflation gets close to 2% … 5% lower than where it is now … and then the screws will ease up. But what happens between then and now?
Rates are tipped to head higher based on the target rate (in the US) of over 5%, so there’s room for the fed to go further, although perhaps not as aggressively.
If inflation continues to drop whilst rates continue to rise, we risk a cycle of distress, which will should show up in the finance sectors first considering they see all of the loans. Tighter policies will see fewer loans and subsequent restricted growth.
If and when things go pop, if inflation drops by 0.5% per month, then the fed (currently) has said (‘rates will stay high for some time’ – paraphrase ) it will watch the economy burn for 3-to-4 quarters before it starts to ease policy.
Related: Quantitative Easing
Economic inertia and things will not go back to normal
Should the worst happen, what are the outcomes? Firstly, let the economy burn or … take a second round of corrective actions. That means … with the worst sense of timing and control, we could expect even more free money to start flowing into the system … well not flow … more like high pressure injection!
But easy cash isn’t a sustainable fix. Businesses don’t just close on Friday and re-open on Monday.
Assets and tools need to be gained, staff need to be onboarded … businesses that fail may never come back … the big players and other survivors will become even more dominant. Lets not even talk about cumulative debt, interest or which generation will pay the bill.
… and if that happens don’t expect prices to return to pre-pandemic levels. Here’s why. Its just a case of the math. Even if inflation drops back to 2% … that’s still a 2% increase on the price from a year earlier … and based on the Fed reserves definition for easing policy … they will start making money cheaper even as prices stabilise … higher than where they are now.
Getting prices back to ‘normal’ would require wholesale deflation, that means seeing CPI and Core CPI numbers going negative for a sustained period, which would mean that things have gone much worse than expected.
As of now, things are all over the place. Fundamentals are in the toilet, but the economy and the regular consumer have shown immense resilience. Between the aggressive financial policies and the resilience of the consumer … someone is going to crack. The only question is whether someone can land this beast or whether its going to crash and lead to another multiyear cycle of what we’ve already been through.
Things aren’t good. But the question is whether, things will just be bad … or worse?