Friday, July 16, 2021
This week has provided investors with a fresh batch of data carrying the potential to heavily affect the inflation debate. Tuesday brought us the Consumer Price Index (CPI) for June, while Wednesday saw the release of the Producer Price Index (PPI) for June as well as the start of Federal Reserve (Fed) Chair Jerome Powell’s two-day testimony to Congress providing an update on the economy.
So has any of this materially changed our view (or the Fed’s) on the great inflation debate? Not really.
This may surprise some given CPI’s and PPI’s large beats relative to expectations, but at least for the next few months we believe that the composition of the inflationary increases is more important than the headline numbers. Headline CPI jumped 0.9% month over month vs. estimates of 0.5%, while core CPI jumped 0.9% month over month vs. estimates of 0.4%. Base effects from rolling off weak numbers a year earlier meant the year-over-year numbers were even more eye-popping. Meanwhile, headline and core PPI both rose 1.0% month over month vs. expectations for 0.5%. Under the hood, though, the theme of both reports is quicker-than-anticipated reopenings are stretching supply chains. The good news there is that those supply chain dynamics have the potential to improve quickly to meet demand and mitigate the lasting effects.
This is especially true in the auto, travel, hospitality, and food industries. Semiconductor shortages, which are already showing signs of subsiding, are driving shortages in both the new and used car marketplaces. As rental car companies increase their fleets to meet demand, they are increasingly being forced to bid up a limited amount of existing supply. Similarly, labor supply shortages in the leisure and hospitality sector, as well as airline travel, are restricting supply and causing prices to skyrocket. These components all tend to be relatively small parts of the overall CPI basket, but at the moment they are driving an outsized degree of the volatility.
All of these phenomena can be described as supply chain bottlenecks, which should eventually resolve themselves. For example, the elimination of supplemental unemployment benefits in September should help increase the supply of labor. Rent prices, though, have a greater impact on overall CPI as they account for 41% of the basket, and increases tend to have greater staying power. While they have risen slightly, they are still under control by historical standards, and play a major part in informing our view that inflation will eventually prove to be transitory.
Fed Chair Powell’s testimony did not break any new ground on the debate either. While the market did perk its ears up when Powell mentioned that the committee is in “active consideration” over when to begin tapering asset purchases, his characterization of inflation as being mainly transitory and affected by supply chain bottlenecks remained steadfast.
“The composition of recent data suggests that inflation will largely prove transitory as the Fed has stated,” said LPL Financial Chief Market Strategist Ryan Detrick. “Just how long ‘transitory’ will prove to be is the big question. We are in the middle of the season when we expected to see some hot prints, so this week has not necessarily been a surprise. But with each passing report market participants will be increasingly anxious to see those numbers start to moderate.”
What is market pricing telling us about inflation? As seen in the LPL Chart of the Day, the market seems to be largely buying into the Fed’s narrative of transitory elevated inflation so far.
Breakeven inflation rates, market-based measures of inflation expectations over given timeframes, rose steadily until roughly the release of the April CPI report when we started hearing about peak inflation concerns. Though that report beat consensus estimates, the subsequent drop in both 5- and 10-year breakevens suggests the market accepted the Fed’s characterization of inflation as transitory.
And while the levels of these series can be volatile, we believe the divergence that began around the New Year is telling. 5-year breakevens began outpacing 10-year breakevens, suggesting that inflation may run hotter in the near-to-intermediate term, but that the market still has faith in the Fed to keep long-term inflation under control. 5-years making a new local high in the last week without 10-years following suit suggests that while the market is slightly concerned that transitory may prove to be longer than originally thought, it does not believe it will cause concerns on a longer horizon.
Rents and wages continue to be areas we monitor as tells on whether inflation may be “stickier” than the market anticipates. Our next good look into wage pressure comes on July 30 when we will receive the second quarter Employment Cost Index (ECI) from the Bureau of Labor Statistics. This report is important because it keeps the jobs mix it looks at constant. If there is wage pressure it may not show up in average earnings data if the job mix is shifting to lower wage jobs, as we likely have now, but the ECI would capture it.
For further analysis on our outlook for the economy and financial markets, please check out our Midyear Outlook 2021: Picking Up Speed.
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