Inflation expectations and Fed’s short-medium-term perspective

Consumer prices… Consumer prices rose steadily throughout the pandemic, and the CPI surprised upwards by 8.6% year-on-year in May. This has fueled concerns about continued price pressure. We are still in the phase of seeing little signs of a regression in inflation. In the June inflation report, we will probably see that the record of 40 years is renewed once again. Even if June marks a peak, we will likely still see very high inflation rates for the next few months until September, as the eventual decline in inflation will be gradual.

Inflation signs… Inflation relief is on the way, but its effects will not be visible in the June report. Commodity prices have fallen markedly in recent weeks, creating a more optimistic perspective for energy prices to fall in July. Food prices are also expected to become more moderate in the near future.

Comparison of CPI, core PCE and Bloomberg commodity index… Source: Bloomberg

Fed perspective… The most important conclusion drawn from the Fed minutes was the general consensus of the attendees on the decision to increase the effective federal funds rate by 75 basis points to quell rising inflation. In addition to the agreed CPI inflation reading, an unexpected increase in long-term inflation expectations measures was effective in this perspective. FOMC officials also noted that the risks to the inflation outlook are on the upside. We’ll be looking at whether FOMC attendees will reassess this view based on more moderate wage growth and lower commodity prices in recent weeks, in statements at the next meeting. In this environment, the Fed would certainly welcome a slower pace of wage growth.

Conclusion? June may be the peak of the annual inflation rate, but the overall trajectory here will actually largely depend on how commodity prices play out over the next few months. If long-term inflation expectations remain stable or rise, it will make it more difficult to achieve a soft landing.

The yield on the two-year Treasuries surpassed the yield on the 10-year Treasury note this week. An inverted yield curve has historically been a reliable indicator of an impending recession. Although the increasing presence of recession indicators brings expectations that the Fed’s momentum will slow down, the Fed is expected to reduce the amount of tightening in the medium term, not in the short term. In the current perspective, the Fed is not expected to stop raising interest rates without seeing a significant resolution in the labor market.

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