The Grinch Arrived Early This Year

Consumer inflation rose to its highest in 30-years – are we doomed?  It’s getting lonely in the “inflation is transitory” camp, as price spikes spread through the economy, no longer confined to sectors impacted by supply chain disruptions or short-term pressures stemming from the reopening. The Consumer Price Index (CPI), a gauge of a basket of consumer goods and services, such as transportation, food, and medical care, rose 6.2% year over year in October while the core measure, which excludes food and energy prices, rose 4.6%, a 30-year high. That’s the fastest annual pace since 1990, cementing high inflation as a hallmark of the pandemic recovery and eroding consumer spending power even as wages surge.

For some color, shelter costs, which makes up about a third of the overall CPI index, rose 0.5% in October, the most in four months as higher rents and home prices feed into the data. Prices for new cars rose 1.4%, used-vehicle prices jumped 2.5%, food is up 5.3% from year ago, the most since January 2009, gas rose 6.1% from September, the biggest gain since March, and electricity costs jumped 1.8%, the largest monthly increase since 2014, and fuel oil advanced 12.3% from the prior month, the most since 2007.

The fallout? The inflation surge suggests higher inflation will be longer-lasting than previously thought, putting pressure on the Fed to end near-zero interest rates sooner than expected and perhaps even force it to quicken the pace of its bond-buying taper announced two weeks ago. On the political front, the inflation surge threatens to exacerbate political challenges for President Biden and Democrats as they seek to pass a nearly $2 trillion tax-and-spending package and defend razor- thin congressional majorities in next year’s midterm elections. The CPI didn’t move the market’s expected timing of the next Fed rate hike much; futures markets still expect a 0.25% rate hike as early as July 2022 and have maintained their strongest expectation of rate hikes in a decade. Despite market expectations, we still suspect we won’t see the first rate hike until Q3 at soonest, but more likely in Q4 2022.

Our take: Turbo-charge demand with fiscal and monetary stimulus at a time when bottlenecks constrain supply, and what do you get? Inflation! If you think inflation at a 30-year high is shocking, buckle your seat belt, it’s going even higher. With the increases in prices being broad-based and in areas tough to remedy quickly, e.g., higher energy prices, intensification of supply-chain bottlenecks along with higher rents, we suspect that CPI won’t peak until early next year, topping out somewhere near 6.9% YoY. While it looks scary now, the pandemic-driven inflation we’re all experiencing now will disappear next year, and be followed by deflation in many categories (ex labor), particularly commodity centric and tech sectors.

For the Federal Reserve, the bar for speeding up its tapering pace is high, and we doubt the Fed will alter its bond-buying pace just yet. But the next two readings of consumer inflation, next month and in January, the final two readings for 2021, will put the Fed’s patience to the test. In the meantime, upward pressure on short-term rates, like the 2-, 3-, and 5-year Treasury yields, key drivers of the cost of rate caps and swaptions, should hold fast. The billion-dollar question now? With consumer prices now running at a faster pace than wages, will workers pressure employers to match the increase, sparking a wage-price spiral and a potentially steeper path of Fed rate hikes.

The Grinch arrived early this year. Directly related to the latest sky-high inflation reading, consumer sentiment plummeted in November, with anxiety about inflation helping to push the gauge to a decade low. The preliminary reading of the University of Michigan’s consumer sentiment index for November fell to 66.8 from 71.7 prior: that’s the lowest reading in 10 years. The consensus forecast was for sentiment to improve (to 72.5).

The report noted that “one-in-four consumers cited inflationary reductions in their living standards in November, with lower income and older consumers voicing the greatest impact.” Consumer prices are now running at a faster pace than wages, a negative sign for real income expectations and demand. On that front, the report also noted that half of all families anticipate reduced real incomes next year. A severe slide in perceived buying conditions for large durable goods and autos continued in November, ahead of the holidays.

Looking ahead, the risk to consumers – whose spending make up 70% of America’s economic activity – is outsize, persistent price rises feed into the consumer-inflation psyche. In the near term, shortages and prices should continue to cause consumers pause. A drift higher in inflation expectations could undermine the Fed’s  – and our – prediction that inflation is indeed temporary, and that core inflation will eventually settle near the Fed’s 2% target. It’s well over 4% now. This year’s holiday spending season is critical for the economy to emerge into next year on solid footing. Will it be a bust? An increasing number of signals are pointing that way.

Want another barometer for where inflation may be headed? Watch China. Like here in the US, wholesale prices faced by Chinese producers, the folks that make all those shiny things we all buy, have been rising rapidly in the past few months, first due to the global commodity price rally and then output curbs caused by a power crunch. Although China’s impact on global inflation has diminished over time, the pickup in Chinese producer prices is another risk factor for many countries – specifically the US –  given China’s status as the world’s biggest exporter. One ray of light? The recent collapse in the price of coal, a favored fuel for China’s factories, from a mid-October peak may limit the bleeding of Chinese inflation into the US.