May CPI Sneak Peek: Inflation Angst is Coming
- The annual CPI is expected to climb to 4.7%, the core at 3.4% in May.
- Federal Reserve interest rate policy tied to labor market recovery.
- Inflation stirs up raw materials, product shortages and wages.
- The Fed appears to have started to prepare the market for bond reduction.
- The US dollar is a reflection of Treasury rates.
When the Federal Reserve shifted its price measure to average inflation last September, governors carefully isolated rate policy from the expected acceleration in consumer costs this year.
Governors did not want their pandemic rate accommodation put under pressure by the credit market’s traditional approach to inflation, which often anticipates the Fed’s policy adjustment by months.
The Fed’s defensive preparation was justified.
This year, annual inflation has tripled in four months, from 1.4% in January to 4.2% in April.
The consumer price index (CPI) is expected to rise 0.4% in May, after advancing 0.8% in April. The annual rate is expected to reach 4.7% against 4.2% in April. The core CPI is expected to rise 0.4% in May after the 0.9% increase in April and the annual base rate is expected to rise to 3.4% from 3% previously.
Inflation: containment price
Consumer prices collapsed last spring. Americans stopped buying except for food and basic necessities and retreated to their homes. The economic recovery and the surge in demand that accompanies it this year produced the predictable spike in inflation the Fed had anticipated.
The annual CPI has risen sharply since the start of the year. From January to February it increased by 0.3%, from February to March by 0.9% and from March to April by 1.6%.
The largest increase in the annual CPI this year, from 2.6% in March to 4.2% in April, reflected the decline a year earlier, from 1.5% in March to 0.3% in April.
If May’s forecast of 4.7% is correct, the base effect has started to weaken. The 0.5% increase from April to May will be less than a third of the gain recorded a month earlier.
The Fed’s calculation that once the distortion of the foreclosure price drop has passed, inflation will return to a normal, and much shallower, upward curve is probably correct. The question for the rest of the year is how much has the underlying inflation rate changed?
In the second half of 2019, the CPI averaged 1.9% per year.
The economic forces that gathered last year will keep inflation above last year’s average. How many above is the known unknown.
Inflation: labor markets, commodities and shortages
Inflation will not return to its pre-pandemic level because the US and global economies are far from normal.
Labor markets remain tight in the United States. A record 9.3 million jobs were cut in April as part of the Job Openings and Turnover Survey (JOLTS), an increase of nearly a million from March.
With dismal hires in April and anemic in May given the number of open positions, employers are offering salary increases and signing bonuses. The cause of workers’ reluctance is probably the extension of federal unemployment benefits. If so, the additional compensation may wane as the program ends in September.
The long-term effect of an increase in wages is unknown, but wages are particularly rigid. It is difficult for a company to lower its pay in a tight labor market while other companies continue to pay higher rates. Chances are the higher pay scales are permanent.
Commodities are another ingredient in the price movement. The Bloomberg Commodity Index (BCOM) is up 23.9% since the close on December 28 last year. It is 57.3% above the pandemic low of April 24, 2020.
West Texas Intermediate (WTI) has gained 47.6% since Jan.4. It is 119.5% higher than its May 19, 2020 result at $ 31.93.
Oil is not only the first commodity of the industrialized world, with participation in almost all aspects of modern production. Oil prices are transferred directly and immediately to the consumer. The national average for a gallon of regular gasoline was $ 2.94 on June 6, 36.1% higher than its price on December 28 of last year.
Finally, production delays and shortages of components and raw materials, mainly computer chips, have reduced the manufacturing of many and varied consumer products. Prices have consequently increased for a wide range of consumer products and foods.
Over the past 25-30 years, globalization and the global supply chain have limited consumer prices.
These lockdown-induced shortages and disruptions have affected factories around the world. There are no cheaper products to sell, in some cases there are no products at all. The pricing power has shifted to many manufacturers and retailers.
Labor and product shortages will eventually ease, but not for several months of further increases. The prices of raw materials depend on demand and this is expected to be strong until the end of the year.
Although the upward pressure on these categories may ease, their contribution to the cost of goods and services is expected to ensure the highest rate of inflation in a decade and it is expected to remain so next year.
Inflation: the Federal Reserve’s interest rate policy
The Federal Reserve has linked its monetary policy to a full recovery in the labor market.
Wages in April and May, barely half of expectations, held back what appeared to be a hasty return to full employment.
The Biden administration complicated the situation by extending unemployment insurance until September. This appears to delay hiring, or perhaps it is more accurate to say, deter some workers from seeking employment.
Treasury rates rose sharply in the first quarter as markets speculated on an acceleration in the US economy. In all aspects except the job market which has been true.
Growth exploded from 6.4% at an annualized rate in the first quarter to about 9.4% at the Atlanta Fed in the second. The purchasing managers’ indices for services and manufacturing are, with the exception of employment, uniformly high. Managers note the difficulty in finding and employing workers rather than having no jobs to offer.
The rapid recovery of the US economy prompted the Fed to begin preparing for a cut and concluding its bond purchase program. The $ 120 billion a month in treasury bills and mortgage assets the Fed bought each month kept the short end of the yield curve close to all-time lows.
The April meeting minutes noted that some members believed the time to discuss the bond program was approaching. A number of other Fed and government officials, including Treasury Secretary Janet Yellen, have expressed similar views.
The April and May payrolls temporarily stifled speculation about falling credit market rates, if they did not silence any public consideration of Fed members.
Inflation has complicated the rate picture. Even after the base effect disappears, inflation is going to be significantly higher this year.
Medium inflation, the Fed’s policy of letting prices rise for a period beyond the 2% target to produce an acceptably higher rate, has eliminated the need to react immediately to consumer prices.
However, if inflation becomes a widespread and persistent phenomenon, the Fed will have to respond. Bond traders can make this almost mandatory.
The US economy will sooner or later force Treasury rates above 2%, even if inflation does not exceed 3% all the time. Fed policy is preparing for this eventuality.
DXY and the dollar
The Dollar Index, and the greenback in general, followed US Treasury rates higher in the first quarter.
From January 6 to March 30, the Dollar Index rose 4.3% to 93.29.
The correlation with the 10-year Treasury rate at the turn was almost exact. The 10-year Treasury yield climbed 83 basis points from December 31 to March 31 by 0.916% to 1.74605. Treasury yields turned lower on April 1 and this benchmark rate has not closed as high since.
10-year US Treasury yield
Interestingly, the Dollar Index lost almost all of its 2021 gains, closing at 90.12 on Tuesday. The 10-year rate held on to 75% of its first-quarter rise, closing at 1.534% on Tuesday. This is another indication that the credit market is expecting higher US interest rates.
Treasury yields have been the interface between the US economy and currency values.
To the extent that the CPI changes perceptions of the Federal Reserve’s future policy, higher inflation can push the dollar up. Interest rates remain, as they always have been, the most important factor in the direction of currencies.
Once the base effect of last year’s foreclosure ends, CPI increases will exert a stronger influence on market perceptions and Fed policy.
It is not yet time for inflation to regain its historic primacy in Fed policy. The incomplete rebound in the labor market is hindering this.
If at the end of the third quarter inflation is still above 3%, it will quickly become a central concern of policies and markets.