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Campbell Harvey, a Duke University finance professor best known for developing the yield-curve recession indicator, says the Federal Reserve’s read on inflation is out of whack. And, as a result, the likelihood that the U.S. slips into a recession is increasing.
The big question now is the severity of the economic downturn to come, if the central bank continues unabated on its high-interest-rate path.
On Wednesday, the Fed, which began raising rates from near zero last year, held them at a range of 5.25% to 5.5%, a 22-year high, in its effort to get inflation under control.
“The [inflation gauge] that the Fed uses makes no sense whatsoever, and it’s totally disconnected from market conditions,” Harvey told MarketWatch in a phone interview.
The Fed’s measures of inflation are heavily weighted toward shelter costs, which reflect the rising price of rental and owner-occupied housing. For example, shelter inflation has been running at 7.3% over the past 12 months, and also as of the most recent consumer-price index, for August. Shelter represents around 40% of the core CPI reading.
Harvey says that’s a problem because shelter’s retreat loosely follows the broader trend lower for headline inflation but at a lag, and the Fed wouldn’t be properly accounting for that lag if it decided to keep its target interest rates restrictively high.
Separately, MarketWatch’s economics reporter, Jeff Bartash, notes that CPI also fails to capture the millions of Americans who locked in low mortgage rates before or during the pandemic and who are now paying less for housing than they had previously.
“The Fed is … using inflation, in what I call a false narrative,” Harvey said.
Opinion: Fed’s ‘golden handcuffs’: Homeowners locked into low mortgage rates don’t want to sell
Also see: U.S. mortgage rates ‘linger’ over 7%, Freddie Mac says, slowing the housing market further
Harvey said that if shelter inflation were normalized at around 1% or 1.5%, overall core inflation would measure closer to 1.5% or 2%. In other words, at — or substantially below — the Fed’s 2% target.
Consumer prices ex-shelter were up 1.9% on a year-over-year basis in August, up from 1% in July, according to the Labor Department.
The Canadian-born Duke professor says that the Fed risks driving the U.S. economy into recession because it has achieved its goal of taming inflation, which peaked at around 9% in 2022, and isn’t making it clear that its rate-hike cycle is complete.
“Now, the higher those rates go, the worse [the recession] is,” he said.
Harvey pioneered the idea that an inverted yield curve is a recession indicator, with the curve’s inversion depicting the yield on three-month Treasurys rising above the rate on the 10-year Treasury note
BX:TMUBMUSD10Y.
Longer-term Treasurys typically have higher yields than shorter-term U.S. government debt, and the inversion of that relationship historically has predicted economic contractions.
Harvey says that that his yield-curve-inversion model has an unblemished track record — 8-out-of-8 — for predicting recessions over the past 70 years. A recent inversion of U.S. yield curves implies that a U.S. recession is still a possibility.
Opinion: The U.S. could be in a recession and we just don’t know it yet
Also see: Are markets getting more worried about a recession? Invesco says a Fed pivot is coming.
On Thursday, the Dow Jones Industrial Average
DJIA
fell 1.1%, while the S&P 500
SPX
tumbled1.6% and the Nasdaq Composite
COMP
slumped 1.8%, marking one of the worst days for stocks in months.
