Inflation acceleration makes Fed uncomfortable
- July 19, 2021
Corporates | Kennett Square, PA
Inflation continued to dominate conversations with elevated CPI numbers leading to tough questions for the Fed chair at his Congressional testimony. The 2-5 year treasury yields increased but long-term yields continued to fall. Meanwhile, OPEC reached a compromise with the UAE, agreeing to higher oil output, raising hopes of potential relief in oil prices.
Tuesday morning official data showed U.S. headline consumer prices rose 0.9 percent last month, exceeding forecasts and posting the largest monthly gain since 2008. This took the year-over-year increase to 5.4 percent and put the Federal Reserve in an uncomfortable position, calling into question their view of a temporary and fleeting price surge. The reading also increases the risk of higher tension and a sharper split within the FOMC on the next steps in setting monetary policy.
What is driving inflation higher?
Taking a closer at the underlying data on some key components driving inflation higher:
A global shortage of computer chips caused new car prices to rise rapidly. Higher new-car prices have led buyers to move to the used-car market. Surging prices for previously owned vehicles accounted for a third of the rise in CPI; they were up 10.5 percent from the previous month and 45 percent from June 2020. It’s an example the Fed has repeatedly observed as an effect of supply constraints, which should reverse, hence their opinion that this is transitory.
Loosening of Covid-19 restrictions and a subsequent surge in summer travels has boosted airline and hotel prices. Airfares in June were up 2.7% and 25% higher than a year ago. Hotel prices were up 7.9% in June and 17% on the year. But prices for both remain below their pre-pandemic levels suggesting they still have room to rise.
Eating out at restaurants has become much more expensive, with food prices 0.7 percent higher month-over-month and 4.2 percent higher than a year ago. This has been attributed primarily to labor shortages and the resulting upward pressure on wages being passed on to consumers.
Owner’s equivalent rent which measures what homes would rent for was up 0.3 percent over last month and 2.3 percent over the last year. Increasing prices here are an area of concern as shelter costs represent the largest and most sticky component of the CPI and prices could continue upward in the months ahead due to rise in real estate prices.
Fuel prices increased significantly this year with gas prices reaching a national average of over $3.10 per gallon, which was the highest in seven years and 40 percent higher than this time last year. With global crude prices remaining above $70 per barrel, there may not be a downward trend here anytime soon.
(Related insight: Watch the on-demand webinar, “Semiannual Market Update for Corporations” with Amol Dhargalkar and Kevin Jones)
Jay Powell in the hot seat
The Fed chair testified to Congress this week and had to field some tough questions on the Fed’s response to surging US inflation after the release of new data.
Mr. Powell acknowledged inflation was above the Fed’s comfort level saying, “This is a shock going through the system associated with reopening of the economy, and it has driven inflation well above 2% and we’re not comfortable with that."
He reiterated his view that the inflation increases would be transitory and eventually subside saying, “It is still the same story. It is still the same parts of the economy that are producing this inflation. It is a pretty narrow group of things that are producing these high readings, but we are anxious like everybody else to see that inflation pass through.”
As Mr. Powell spoke, the Fed released its Beige Book, saying, "The majority of respondents expected further increases in input costs and selling prices in the coming months." It also said supply-chain disruptions became more widespread for both labor and materials, and that businesses reported low inventories and delivery delays.
The Fed maintains it is still riskier to tighten policy too early than too late and are wary of pulling back their support for the U.S. economy. The labor market is still far short of its pre-pandemic employment levels, and fallout from the global pandemic with the spread of the Delta variant could still pose risks to the economy.
Impact to interest rates and swaps
As the Fed pushed back against concerns about inflation and reiterated its commitment to maintaining its current course until there was more certainty around the economic recovery, long- dated U.S. Treasuries rallied. The 10-year treasury yield was lower by 25bps compared to a month ago, whereas short- to mid-term Treasury yields increased on account of inflation. This has steepened the swap rate in the 2-5 year maturity range.
(Visit Chatham Rates to view current Treasuries and swap rates)
In the coming week, housing data will be released along with manufacturing and services PMI, which should provide additional information on prices and economic activity.
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