The past week saw not one, but two shocks on the inflation front. The report from the US Bureau of Labor Statistics on consumer prices released on Tuesday showed that the headline (overall) index rose by 0.3% in January, faster than the 0.2% expected, as well as the 0.2% posted in December. Although the increase over the past year at 3.1% was less than the 3.4% in the previous month, it defied expectations that the figure would have a 2-handle. Also, core consumer prices (which exclude food and energy) showed no improvement, rising by the same 3.9% year-on-year as had been the case in December.
A worrisome aspect was to be found in the weeds. The cost of shelter, that had been expected to decline and contribute to a deceleration in inflation, actually rose by 0.6% during the month. Shelter cost was responsible for two-thirds of the increase in the overall index.
Yesterday produced the second shocker, this time with a much higher than expected Producer Price Index. The PPI rise of 0.3% last month was much hotter than the 0.1% increase that had been anticipated. The January increase followed a 0.1% decline in the index in December. Even though the price index for goods fell by 0.2%, that was more than offset by a 0.6% rise in the cost of services.
The characteristic shared by both the CPI and PPI reports this past week is that while inflation in goods prices slowed, or actually fell, as anticipated, the increase in service cost was more than expected, pushing up the overall indexes. This is consistent with my repeatedly stated hypothesis: With the amount of monetary and fiscal excess that the US economy experienced during 2020 - 2022, trying to contain inflation without inflicting pain will result in whack-a-mole type of shifting price pressures rather than total containment. Of course, promise of pain-free reduction in inflation was what Federal Reserve Chairman Jerome Powell had offered until just prior to being confirmed for a second term in May 2022.
The inflation reports had an electrifying impact on bond markets. The yield on 10-year US Treasurys closed last night at 4.28% after starting the week at 4.17%. The impact was even great on two-year obligations which are considered to be a reflection of market expectations for future Fed policy. Two-year Treasurys zoomed in yield from 4.46% on Monday to close the week at 4.67%. The yield curve became more inverted.
Some market observers have tried to belittle the importance of the two inflation measures, suggesting that start-of-the-year effects and changes in methodology may be the reason for the unexpectedly high inflation numbers which will be ignored as the year goes along. Did these analysts realize the importance of the beginning of the new year only this week? You have to wonder why those who were wrong with their predictions did not factor these into calculations when they put out forecasts of a marked slowdown in inflation in January. Excuses, excuses, excuses!
There are two major implications of the continuation of high policy interest rates, one for the Federal Reserve, the other for the overall economy and markets. In the case of the Fed, higher-than-expected inflation rates put the kibosh on any plans doves in the central bank may have had to start lowering the Federal Funds rate at the conclusion of the next meeting on March 20.
Given that neither consumer nor producer prices behaved in a manner consistent with lowering inflation to the Fed’s 2% target, and with average hourly earnings rising at a 4.5% annual rate, it would be irresponsible to lower rates in a few weeks. The Fed’s typical response that the collective impact of the 5 1/2 percentage point increase in interest rates will suffice to lower inflation to target is not working out!
The second implication relates to what elevated interest rates may do to troubled sectors of the economy that would have benefited from rate reductions — among them, debt-laden consumers falling behind on payments, commercial real estate that would benefit from reduced debt service cost, and banks that loaded up on long-dated debt instruments after Powell assured them that the pickup in inflation during 2021 was “transitory”.
These entities will have to deal with higher rates for longer unless, you guessed it, something breaks in the system, forcing the Fed to resume Quantitative Easing and cut rates.
Of the two strikes that the Fed encountered on the inflation front this past week, the second, relating to the PPI, has another serious consequence. Some of its components go into the Personal Consumption Expenditure (PCE) price index that the Fed relies on to set future policy. The next PCE release will be on February 29 and, already, forecasts are being revised upward after yesterday’s PPI statistic.
What will happen to the Fed’s credibility when it strikes three times in the same month?
Dr. Komal Sri-Kumar
President
Sri-Kumar Global Strategies, Inc.
Santa Monica, California
srikumar@srikumarglobal.com
@SriKGlobal
February 17, 2024
Sri-Kumar Global Strategies, Inc. advises multinational investors and sovereign wealth funds on global risk and opportunities. Dr. Sri-Kumar is regularly featured on business TV and Radio media, and is a frequent speaker in global financial centers on major topics that affect markets and investments.
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