Despite being consistently wrong on inflation throughout all of 2021, Fed Chair Jerome Powell and other policymakers at the Fed have largely convinced market participants that the ongoing spike price pressures will continue to be “transitory”. Consumers, on the other hand, are not so easily convinced. And neither are we. With rent prices, representing a third of the CPI’s components, finally beginning to creep up, elevated inflation data is unlikely to roll over anytime soon.
Despite seven consecutive months of intensifying inflationary pressures, the Chairman of the US Federal Reserve, Jerome “Jay” Powell, has managed to convince market participants that rising prices will be “transitory”.
According to Bank of America’s most recent Global Fund Manager survey, just 22% of 239 surveyed fund managers expect inflation to rise in the next 12 months and 70% expect inflationary pressures to be transitory rather than entrenched, in line with the view of the Federal Reserve. An identical portion of fund managers expect the Fed to signal a tapering of asset purchases in August or September. To be sure, there have been a number of respective voices arguing against the transitory view. But that is not the consensus. We can observe how traders are pricing in the inflation outlook by taking a look at the bond market.
Treasury yields, in particular, tell the story of how the Fed chair has convinced the markets not to worry. Treasuries maturing in 10 years recently dropped back to 1.25%, after more than tripling from an 0.52% trough in 2020 to a peak of 1.74% this year. That unequivocally illustrates an easing of expectations for rising longer term rates, even as actual inflation data has exploded upward.
Moreover, breakeven calculations for inflation expectations – the difference between the yield-to-maturity of a conventional Treasury coupon bond and that of a Treasury Inflation-Protected Security (TIPS) bond of the same maturity term – have largely flattened out. The 10-year and 5-year breakeven rates, for example, have largely been rangebound for two months now, between 2.2%-2.4% and 2.3%-2.6%. Though each of those rates are significantly higher than this time last year, when they were both stuck below 1.6%, the bond market clearly appears to think the worst of the inflationary pressures have passed.
While financial market participants seem to be buying the Fed’s transitory talk, much of the public has leaned the other way. The University of Michigan’s survey of consumer sentiment, for instance, saw inflation expectations for the next 12 months break out to 4.7%, a nearly 13-year high this month. Expectations for the next 5 years remained elevated at 2.8%.
A similar consumer survey from the New York Federal Reserve found inflation expectations to be slightly higher at 4.8%, the strongest reading ever in that set of data, going back to 2013. Expected inflation three years from now held steady at 3.6%.
Those expectations have undoubtedly been boosted by the actual inflation data that has already exploded. YoY growth in the headline CPI print has skyrocketed from 0.2% in May 2020 to 5.3% last month. Believers in “transitory” factors driving prices higher cite base effects, supply-chain disruptions re-opening demand surge, etc.
Prices Put Ever More Pressure on Powell
While all of those explanations are true to an extent and can be expected to dissipate eventually, we suspect they will not fade quickly as many are hoping for.
In fact, as we close in on the end of the year, weak comparisons from the prior year will likely create another leg up in annual inflation prints. The Core Personal Consumptions Expenditures (PCE) index, the Fed’s preferred gauge of inflation, jumped out to a 30-year high of 3.5% in June. That’s well above the Fed’s average inflation target of 2.0% and marks the third consecutive month of the Fed’s preferred gauge of inflation pressing above the 3.0% threshold.
Even with MoM prints as low as 0.2% for the rest of the year, the annual gain in the core PCE would remain above 3.3% for the duration 2021. If we project 0.4% MoM in the Core PCE through the second half of the year, equivalent to June’s increase, we can expect a YoY reading as high as 4.9% in the index by the end of 2021.
Though Fed officials now assume PCE inflation will rise by 3.4% this year, that is a significant upward revision from their full-year projections of 1.8% last December and 2.4% in March. Given the fact…
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