Is inflation here to stay? According to Federal Reserve Chairman Jerome Powell, the recent uptick in inflation is transitory. The Federal Reserve in the United States believes that the issues created by elevated inflation levels are temporary. While the view is that prices will not start to decline, the upward momentum in price activity could decelerate. The markets are beginning to price in elevated levels of inflation. U.S. Treasury yields have increased from 1.25% to 1.50%. Additionally, the September 2022 Eurodollar contract is pricing a 100% chance that the Fed will raise interest rates. Forex trading is also pricing in higher inflation levels, as rising U.S. Treasury yields have buoyed the dollar.
What is Inflation?
Inflation is generally described as the increase in the price of a basket of goods and services. Each country around the globe has a definition of what they considered their official inflation gauge. When prices of goods or services that you use rise, you are experiencing inflation. Inflation is naturally occurring and usually makes its way into wholesale prices before it reaches the consumer. Several countries feature both a producer and wholesale price inflation index as well as a consumer price index. The consumer price index reflects inflation at the retail level. This inflation impacts consumers’ everyday lives. Generally, two critical components of the consumer price index are reported. There is a headline number and a number that excludes both food and energy. Since food and energy prices are volatile, the x-food and energy numbers reflect underlying inflation.
Core Personal Consumption Expenditures
In the United States, the Federal Reserve uses a specific gauge of inflation called Personal Consumption Expenditures. The U.S. Commerce Department released this figure. The preferred gauge used by the Fed is the figure excluding food and energy. The uptick in PCE excluding food and energy has reached a 27 year high and has been one of the reasons why forex trading has favored the U.S. dollar.
Why is Inflation So Elevated?
The value of fixed income securities is pricing in current inflation levels. The question traders need to answer is whether inflation could continue to accelerate. There are two measures of core inflation (excluding food and energy) that make up the bulk of the inflation calculation: wage inflation and rent-equivalent inflation. Wages move higher when there are more jobs than people available to work at those jobs. The rent-equivalent is the price of homes and rent. Housing prices are near their highest levels on record in 2021, and inventory levels in conjunction with lower interest rates should keep prices elevated.
Are We Head for a Great Inflation?
The question of whether inflation will continue to accelerate is a function of several factors. The first is when the Fed will pull the trigger on higher interest rates. As mentioned previously, the September 2022 Eurodollar futures contract shows that the market expects the Fed to raise interest rates by the end of the third quarter in 2022. The market also expects the Federal Reserve will begin to taper its bond purchase program, which could reduce the liquidity in the market and therefore reduce inflation.
Once the Fed increases interest rates, the market will price in additional rate hikes significantly, if inflation is accelerating. Remember, the U.S. Federal Reserve targeted Fed Fund rates at 1.25-1.5% in 2017, which was the high point following the Great Recession in 2008-2009. So, while there is a chance that inflation will accelerate to slightly more elevated levels than what’s current, it’s unlikely to stay at those elevated levels if the Fed is raising interest rates.
Fed officials have been talking down inflation. Recently the Fed’s Charles Evans told CNBC that he sees inflation falling below the Fed’s 2% target after the transitory rise is complete. With the PCE at 3.6% year over year, it will take a lot for prices to continue to accelerate at elevated levels.
Remember, if an apple price rises from $1.0 to $1.04, it has increased by 4%. It would need to climb to a price above $1.08 for inflation to remain at 4%. If the prices remain elevated at $1.04, then inflation is zero the following year.
The Bottom Line
Inflation is rising, but the accelerating in prices is likely to flatten. Once the global central bank community begins to raise rates, prices could start to level off. The market is currently pricing in a 25-basis point increase in rates by September 2022. Market participants also expect the Fed to begin to taper its bond purchase program in 2021. Rising interest rates historically have put downward pressure on prices. While the Personal Consumption Expenditures rate is 3.6% above the Fed’s target of 2%, they will likely allow it to remain hot until economic growth gains traction in the United States.