Inflation Expectations Are On The Cusp Of Becoming Unanchored
HadelProductions
It was a very volatile week of trading following the inline CPI report. With the market rocketing higher but had a tough time digesting the inflation data, only to give all those gains back on Wednesday. Then on Friday, the University of Michigan added another unexpected wrinkle when its survey of inflation expectations over the next 5 to 10 years climbed to 3.2%, much higher than the expected 2.9%.
What's clear is that wage growth, month-over-month changes in the CPI, and consumer inflation expectations are inconsistent with the Fed's 2% inflation target. That will make the market's view of rate cuts later this year very hard to accomplish.
Risks of Unanchoring Inflation Expectations Rise
While many investors tend to dismiss consumer inflation expectations due to their relationship with things like gasoline or dining out, the recent rise in consumer inflation shouldn't have happened because we have generally seen gasoline prices falling. It would either suggest that the University of Michigan's preliminary number that came out on Friday is too high and will be revised down, or there's something else that consumers are considering regarding where inflation is heading.
Bloomberg
It isn't only the University of Michigan survey that has recently seen an uptick in inflation expectations. The NY Fed reported an uptick in three-year inflation expectations in April. Whether or not that trend continues in May and June will be immensely important, especially if the University of Michigan revision sticks.
Bloomberg
If that University of Michigan number sticks, it would be the highest final reading for that metric in years, and that 3.2% in the past has only been surpassed on a handful of occasions over the last 30 years. In some ways, it appears to be a delineation between well-anchored and unanchored inflation expectations.
Bloomberg
These consumer-based expectations may even serve as a better guide to where inflation is going than the market-based inflation expectations have. Because when looking at the data, it almost appears that the consumer has seen the bottom and the top of the inflation range before the market-based expectations.
When comparing the NY Fed's 3-year ahead inflation expectations with the three-year breakeven inflation expectations, along with the University of Michigan's 5-10 year inflation expectations, with the five-year breakeven, it is pretty easy to see how the consumer-based expectations bottomed and topped months before the market-based measures.
Bloomberg
While this may not suggest that inflation rates are going to new highs, it could indicate that inflation will remain very sticky and elevated and may oscillate in a range. It also suggests that market-based inflation expectations will rise again as the market realizes that inflation will be an issue for some time longer.
It moves the inflation battle into a dangerous spot because we could be at a point where inflation expectations are rising merely because inflation has been so elevated for such a long time that the expectation is for inflation to remain high. If there has been a shift in this psychology, then it will mean that the market will soon pick up on this trend, resulting in higher market-based measures of inflation.
Unanchoring Inflation Expectations Risks Higher Volatility
If those market-based inflation expectations shift higher, it will work to remove rate-cut expectations from the market as yields rise and, in turn, create even more volatility in the market as it tries to figure out what comes next in terms of monetary policy.
Unfortunately, most investors associate volatility with the VIX rising or the stock market going down. But realized volatility works both ways when the market rises and falls. In fact, after hitting a low in mid April, realized volatility has been on the rise, and that is primarily due to the wide swings witnessed in the market as it tries to digest all of this economic and earnings data that seems to be pointing in multiples directions, as well as the potential impacts from the recent bank failures.
Bloomberg
One would expect that if realized volatility continues to rise as market swings become larger, implied volatility would also follow in time, especially as we move toward data points likely to affect how the Fed may lean into the June FOMC meeting.
This Week's Test
One such event will happen this Friday, when FOMC chairman Jay Powell and Former FOMC chairman Ben Bernanke will discuss the monetary policy at a conference held by the Fed on Friday, May 19, at 11 a.m.
This will be the market's first opportunity to hear Powell's thoughts on the current inflation and job data and see if the University of Michigan data caught his attention as it did at the June 2022 FOMC meeting.
All of this, in combination, will likely lead to only more market volatility again this week and in the coming weeks as we find out if inflation expectations have indeed shifted and whether the incoming data suggest the Fed may need to raise rates even more.
Source: Seeking Alpha
