Inflation Is High But Inflation Expectations Are Still Anchored… For Now.

Posted by Lawrence Gillum, CFA, Fixed Income Strategist

Thursday, September 15, 2022

Tuesday’s Consumer Price Index (CPI) release surprised to the upside with core inflation remaining stubbornly high. (For more details on Tuesday’s release, please see our blog post here.) Moreover, the breadth of inflationary pressures broadened in August so alternative measures of inflation that, for example, strip out higher and lower outliers continued to move higher. And while there were some categories that eased, August saw the largest recorded year-over-year price increases in food (since 1979) and electricity (since 1981). So, clearly, inflationary pressures continue to run hotter than the Federal Reserve (Fed) is comfortable with.

As a result, the Fed will likely increase interest rates by at least 75 basis points (bp) at its meeting next week to take its short-term interest rate to 3.25% (upper bound). Assuming the Fed does raise rates by 75 bp next week it would be the third time this year. Over the previous 30 years, the Fed only raised rates by 75 bp one other time. So, the Fed is taking the inflation problem seriously with these jumbo-sized rate hikes. However, according to a recent study from the Federal Reserve Bank of San Francisco, about half of the elevated inflation levels are caused by supply-driven factors and not due to excess demand. And Fed Chairman Jerome Powell has admitted that the Fed’s tools don’t work on supply-related challenges. So why, then, is the Fed continuing to push interest rates higher in an attempt to slow the economy? Frankly, it’s to make sure inflation expectations don’t become unanchored.

Inflation expectations are simply the rate at which consumers and/or businesses expect prices to rise in the future. They matter because actual inflation depends, in part, on what consumers expect it to be. If consumers expect prices to continue to move higher, then they will likely change behaviors and inflation then becomes a self-fulfilling problem. There are three primary ways to track inflation expectations: surveys of consumers and businesses, economists’ forecasts, and market-implied inflation-related instruments. And as seen in the LPL Chart of the Day, market-implied inflation expectations are seemingly well anchored. After spiking earlier in the year, market-implied inflation expectations have fallen back to levels seen earlier in the last decade. Moreover, markets expect inflation to average 2.25% over the five year period, five years from now (2027-2032), which is the Fed’s preferred way to measure long-term market-implied inflation expectations. So by one measure at least, inflation expectations remain anchored.

View enlarged chart.

So, while the Fed is potentially hamstrung in its ability to fully fight current inflationary pressures, it will likely have to stay committed to increasing interest rates to make sure consumers and businesses don’t expect higher prices to continue. “Not taking current inflationary pressures seriously, would likely cause a repeat of the 1970s and 80s,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “Inflation expectations became unanchored in the 1970s and it took three years and two recessions to bring inflation expectations back to more normal levels. That is not something the Fed would like to repeat.”


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