More Importantly, How High Will The Fed Let It Go?
The chatter around inflation is building by the day it seems. The May CPI release expecting headline inflation to come in at 4.7% and core inflation at 3.5% (both figures are yr/yr) would mark the largest increases since 2008 and 1993, respectively. That said, coming out of a recession or in this case a pandemic-induced recession, pricing pressures should build as the broader economy comes back on-line. This time may be even more challenging given the unevenness of the macroeconomic rebound globally and with different regions at various stages in their recovery. Coupled with rising commodity prices (expected), chip shortages (exogenous) and employment pressures in getting those working pre-pandemic back to work (expected but partly due to policy decisions at least in the near-term), the balance between wage inflation and unit cost inflation is stressed. Over the past two decades, services inflation (ex-energy) has increased ~2.7% whereas goods inflation has been non-existent, however, now we are seeing goods inflation of size for the first time in a while and the question now is are we in a transitory stage (as the Fed sees it) or are we at the beginning of a multi-year inflationary paradigm. We are in the camp that there will be elevated levels of both services inflation and goods inflation for the rest of this year and into early 2022 before the goods inflation likely recedes to a level above zero but well off from where it will likely be in the coming months. Additionally, with regards to services inflation, this will likely remain elevated for some time (though the macroeconomy has been better at digesting this throughout history as productivity (think technology) usually is able to dampen outsized moves higher in due course) before retreating to the level seen over the past two decades or just slightly higher. In conclusion, we believe that overall inflation once the Fed’s transitory period has passed will likely be above their stated goal of ~2%, probably closer to ~3% which will likely lead to elevated levels of volatility in the coming quarters in both equity and fixed income markets.
One final thought…given the move lower in the 10-year U.S. Treasury yield over the past week or so, the bond market may be signaling that it is getting more comfortable with the broader inflationary environment as it unfolds. Something to watch as the bond market is usually ahead of the equity market in reconciling underlying inflation within the broader economy.
Shawn S. Tesoro
Chief Investment Officer
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