The US Consumer Price Index report is the topic of today’s “Data” section. Three thoughts:
#1: A hotter than expected print (+6.2 percent headline, +4.6 pct core) is resetting market expectations for the pace of Fed bond purchase tapering and the timing/magnitude of any change in policy rates.
10-year Treasury yields spiked by 12 basis points, to 1.57 percent and recent history says that’s a notable move:
- Over the last year, 10-year yields have risen by 10 bp or more just 3 times: November 9th (last year, 13 bp), February 25th (16 bp), and March 12th (10 bp).
- S&P daily returns for these 3 days average to -0.4 percent, albeit with a wide range (+1.2 pct to -2.4 pct). Today’s 0.82 percent decline is therefore generally consistent with how markets take sudden spikes in long term rates.
Fed Funds Futures are interpreting this statistically unusual move in 10-years (+3 standard deviations, by our math) to mean that the Fed may: 1) accelerate its tapering schedule and 2) raise rates sooner and more aggressively in 2022:
- According to the CME FedWatch tool (link below), the odds of Fed Funds being higher than today in June 2022 stand at 67 percent. That is appreciably higher than yesterday (51 pct) and also above last week’s probability (63 pct).
- The odds that the Fed will raise rates 3 or more times next year now stand at 49 percent, up from 29 percent yesterday and 45 percent a week ago.
Takeaway: today’s market action was all about investors adjusting their views on Fed policy. If they really thought +6 percent inflation was the “new normal”, asset prices would be much, much lower. Even 5-year TIPS inflation breakevens are only looking for 3 percent over the next half decade.
#2: While “Food at home” is only 8 percent of headline CPI, it has an outsized effect on how Americans experience inflation. Grocery bills drive the narrative around the topic even more than gasoline (4 pct of CPI). This chart shows food at home (blue line) and protein (meat, fish, etc, red line) inflation back to 2010. Proteins are the largest part of the food at home basket, at 24 percent.
We’ve highlighted the key issue in the graph: US consumers have seen sequential increases in food inflation through 2020 and 2021. Protein inflation of 12 – 13 percent each year are the primary driver of that inflation. There was pronounced food/protein inflation in 2011 and again in 2014 (4-6 pct and 8-9 pct), but the 3-year lull in between took some of the pressure off consumers. Now, food as a category is 9 percent more expensive than 2 years ago and proteins are 19 percent dearer. Overall 2-year CPI inflation may be “just” 7.5 percent, but consumers will be excused for thinking it is much higher.
Takeaway: the price of food is where the public’s real-world perceptions of inflation most sharply come into conflict with fiscal and monetary policy. This is, we freely admit, a mushy topic because it is not clear how consumers will respond (either politically or with their pocketbooks) if/when food inflation continues to climb. Neither the US government nor the Fed can do much about bottlenecked supply chains or higher feed and fertilizer prices. But one thing is certain: food inflation, regardless of its CPI weight, is and will continue to be a problem for policymakers.
#3: This month’s headline Shelter inflation reading of +3.5 percent was unduly influenced by hotel prices (+26 pct) but Owners’ Equivalent Rent (housing inflation, +3.1 pct) still bears watching. OER is 22 percent of headline CPI and 30 percent of core inflation.
This chart shows the historical relationship between OER/housing inflation (red line) and overall CPI inflation (blue line) from 2010 – present. As noted, from 2013 – 2020 housing inflation was the anchor that kept overall inflation first from slipping negative (2015), and later actually getting to the Fed’s 2 percent goal (2017 – 2020). Now, as visible on the rightmost part of the chart, housing is preventing headline CPI from being much higher (+7 percent).
Takeaway: since it is safe to assume OER/housing inflation will at least get back to 3 percent, seeing an overall 2 percent inflation reading (the Fed’s stated goal) requires less than 2 percent price increases everywhere else in the CPI basket. That’s exactly what happened from 2012 to 2014, as the chart shows. The difference between then and now is a much stronger US/global economy as well as supply chain issues and labor shortages. The bottom line here is that 5-year TIPS probably have it right: 3 percent (not the Fed’s 2 percent) inflation is the most likely scenario. Not horrible, and certainly not enough to cause a recession on its own, but we’ll likely be talking about inflation long past 2022. The math doesn’t work any other way.