Is inflation heating up?

Wade Fowler, Senior Trust Portfolio Manager
Daniel Morgan Senior Portfolio Manager

The April Consumer Price Index report issued by the U.S. Bureau of Labor Statistics on May 12th has received a tremendous amount of attention since its release. The report showed U.S. inflation at 4.2%, a level not seen since 2008 (see Figure 1). Since the report’s release the investment community has actively debated how long we should expect to experience inflation at such a high level.

Figure 1

Source: U.S. Bureau of Labor Statistics

Many investors, and most of the Federal Reserve Open Market Committee, currently attribute much of the increase in the April inflation numbers to supply chain interruptions and a short-term spike in consumer demand. Much of this dynamic is explained simply as effects of reopening from pandemic closures and deemed “transitory.” For others, the high inflation report is an indication of a more fundamental and long-lasting shift to an environment of higher inflation. The resolution of this debate will be seen over time as the inflation picture develops.

Investor’s attention to inflation is understandable from a couple of perspectives.

First, the high valuations we see throughout much of the U.S. equity market are predicated on a low level of inflation. If inflation is set to move higher in the future, equity valuations will likely need to adjust lower in response.

Second, if inflation increases to a level the Federal Reserve deems counterproductive to healthy economic conditions, the Fed will act to put policies in place to remove excess liquidity from the economy. This action would (at least in the short-term) be viewed as a negative development for equity markets.

For years, investors globally have allocated more heavily toward U.S. equities than would have otherwise been the case given extraordinary policies employed by the Federal Reserve. These accommodative policies were aimed in part to encourage additional risk-taking in the economy and have been successful in that regard. A shift in Fed policy that investors view as driven by a change in longer-term inflation would be a significant development.

Federal initiatives could impact inflation rates.

There is a lot of current debate about when the Federal Reserve will raise interest rates. During the last Federal Open Market Committee meeting the Fed outlined a new mandate stating that inflation (measured by the PCE Index) will have to rise over two percent and the economy will need to be at full employment before tightening begins. This could trigger a hike at the end of 2023!

Members of the Federal Reserve have also been rumored to be possibly embracing a “Yield Curve Control Strategy” on the short end (two-three years), that would explicitly prevent the two-year to 10-year yield spread from steepening. This would not only keep short-term rates low, but also interject into the medium/long-term portions of the yield curve with bond purchases in the open market – keeping all rates low.

Figure 2

Source: Cornerstone Macro

More recently, a slew of economic data pointed to higher inflation. First quarter real GDP expanded at an annual rate of 6.4% as a massive 10.7% surge in consumer consumption boosted growth. GDP is set to match its pre-pandemic peak set in the 4Q of 2019. Closely watched inflation measures like the PCE index climbed to an annual 2.3% in the 1Q of 2021, while April’s Consumer Price Index surged to 4.2%, the largest jump since 2008. The consensus among bond investors is that the Fed will raise short-term rates sometime in the 2Q 2021. Yet, recently proposed Biden Administration legislative policies that include corporate and personal tax hikes, targeted for release next year, are expected to slow future economic growth and inflation.