Inflation – Back By Popular Demand

Inflation is probably the biggest known risk facing equity markets today. Last week’s CPI report was expected to be high and still exceeded expectations. The 4.2% year-on-year increase in the All Urban Consumers index (CPI-U) was boosted by comparisons with a year ago. The Fed, and many economists, have warned of the transitory base effects as weak readings from the start of lockdowns drop out. The CPI-U less food and energy is running at 3% p.a., although as is often pointed out eating and driving are not optional even if their costs are volatile. Most striking was the 0.9% monthly jump in CPI-U ex food and energy. Used cars and trucks were up 10% and contributed a third.

The Fed expects inflation to temporarily increase before supply constraints ease, moderating price hikes. Investors aren’t so sure, given the Fed’s stated willingness to tolerate higher inflation until they’re sure we’ve reached full employment. Under such circumstances, the term structure of interest rates should reflect a premium above the Fed’s guidance. The FOMC projects an unchanged policy rate through at least 2023, whereas eurodollar futures are priced for tightening at the start of 2023 and 0.75% by year’s end.

We’ve noted before the FOMC’s poor forecasting record, even of their own policy rate (see Bond Market Looks Past Fed). Markets are skeptical about the Fed’s resolve to maintain expansionary policies in the face of rising inflation. It’s analogous to when a central bank defends a currency peg. Credibility counts for much, and the 0.75% gap between market rates and FOMC projections measures the degree of investors’ disbelief.

Price hikes are visible everywhere. Many corporations report price pressures. Warren Buffett noted that suppliers were increasing costs to them which were being passed on and accepted by customers of Berkshire’s many operating businesses. Hiring is hard. The non-farm payroll report fell well short of the one million jobs expected, but rising hourly earnings suggest more labor tightness than the 6.1%  unemployment rate implies. There’s reason to suspect that job growth was constrained by the insufficient availability of qualified people.

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Disclosure: We are invested in all the components of the American Energy Independence Index via the ETF that ...

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