Consumer Price Index Hike Shocks, but Doesn't Tell Whole Story

The Consumer Price Index jumped a stunning 4.2% in the 12-months ending in April. That's the highest print since oil prices were topping $100 in 2008. Even excluding volatile food-and-energy prices, consumer inflation rose 3.0% in the past year. While everyone has been expecting short-term effects to push inflation higher for some time now, the CPI release on Wednesday is garnering a significant market reaction. Here's how I'm thinking about this release and what it tells us about inflation going forward. Some Noise, Some Signal There's a lot of noise in this CPI release that makes the headline figures hard to interpret. First, is the so-called base effect, or the fact that plunging prices in April 2020 is causing this April's year-over-year measure to be overstated. I've been tracking annualized inflation since February 2020 to get a cleaner look. Over that period, core CPI is up 2.19%. For context, year-over-year Core CPI averaged 2.18% in calendar 2019. There are also some very large single-month price increases in this report that are unlikely to persist. Used cars were up 10% and made up about a third of the overall CPI increase in April. Other outsized price increases included airfare (up 10%), car rentals (up 16%), hotel rooms (up 9%) -- you get the picture. While those price increases are probably real, they also probably aren't going to keep rising. Remember that inflation is a rate-of-change measure. If used car prices rise 10% in April and then just remain at that level, the effect on CPI going forward will be nil. This kind of thing is exactly what the Fed has in mind when it says there will be some transitory inflation. Tight supply of things like rental cars can cause those prices to lurch higher. This probably isn't the last time we'll see an outsized CPI print due to supply-chain issues. The surge post-vaccine travel, various input shortages, and pandemic-era under production of various items are all contributing to inflation. But within fairly short order, most of those effects will subside. The Fed will focus on what the trend rate of inflation is after all that has passed. Market Reaction: A Preview of What's to Come The immediate reaction to the CPI report on Wednesday should be a guide for how markets will react to good economic news going forward. The yield curve bear flattened, which means that all yields rose, but shorter-term rates rose by more than longer-term rates. This move partially unwinds a big steepener that came post-payrolls on Friday. That's a switch from how markets were acting up to around March. Good economic news usually caused a bear steepener (where long rates rose by the most). This was because better data was interpreted as causing more inflation. Since the Fed had pledged to keep short rates low even if inflation rose, that mean that inflation pressure only impacted longer-term rates. Now that inflation expectations are already at the upper-end of the Fed's comfort zone, good economic news won't cause more inflation to get priced in, rather it will cause more rate hikes to get priced in. That said, the move Wednesday is relatively small and doesn't indicate a major change in how markets are thinking about Fed action. Futures markets have added about 7 basis points to expected yields by the end of 2023. This basically brings it back in line with where those futures were trading pre-payrolls. Also, mortgage bonds are actually outperforming Treasury bonds, which indicates markets aren't pricing in quantitative easing tapering any sooner than before this number. There's a Way, but Is There a Will? Shortly after the CPI report, Fed Vice Chair Richard Clarida spoke at a meeting of the National Association of Business Economics. He downplayed April's CPI report one data point and said he expects inflation to subside in 2022. However, he also said that the Fed would not hesitate to use our tools to combat inflation if it rose beyond their comfort level. Fed Chair Jerome Powell used similar language after the April Federal Open Market Committee meeting. The Fed's will to combat inflation has been a hot topic since the pandemic began. On Monday, famed investor Stanley Druckenmiller coauthored an opinion piece in the Wall Street Journal arguing that the Fed should tighten now, lest it lose the will to tighten later. We won't know for sure until such time as inflation has actually run above target for long enough to justify tightening policy. But I am inclined to take Powell and Clarida at their word, and will act accordingly in my trades. I already mentioned that we should expect the middle part of the yield curve to be especially vulnerable. That also probably goes for stocks that are interest-rate sensitive. On Wednesday, we saw fast growing stocks far underperform value-oriented stocks. That, too, is probably a preview for what the tightening cycle ultimately looks like. What Would Cause Inflation to Last? So if this CPI print doesn't indicate that trend inflation is accelerating, how will we know when it is? Given the myriad of distortions the pandemic has wrought, this won't be easy. So, we need to look to the labor market. Inflation can't persist without wage growth, and a tight labor market will be the driver of wages. This week I was asked on Twitter how we'd know if the Fed was behind the curve. Given the average inflation targeting framework, this is a trickier question than it was in the past. I'd say, however, it would be that core personal consumption expenditure inflation is accelerating to 3% or higher and wage pressure is similar to what we're hearing now and prime-aged employment/population ratio is above 80%, which would reverse all the pandemic decline. That would be a circumstance where inflation would be high and all the ingredients would there for it to persist that way. If the Fed were to wait until that moment to tighten, it would have probably waited too long. But the Fed probably won't wait that long. If I had to guess, I'd say that as we get into 2022, the pandemic-related inflation noise will subside, but it will be replaced by more lasting elements. This will probably be at least somewhat evident by the end of 2021 or the start of 2022, which will be when the Fed will start tapering QE. If inflation gets to 2.5% or so and stays there through the late part of 2022, the Fed will start signaling that rate hikes are coming sooner than later.

Consumer Price Index Hike Shocks, but Doesn't Tell Whole Story

The CPI jumps an eye-popping 4.2%, but a lot of noise is included in that number.

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