August 17th, 2012
One of the week’s last data elements was remarkable not for its headlines but its insights on price behavior. In the University of Michigan’s Consumer Sentiment survey, the one-year ahead median inflation figure jumped from 3.0% in July to 3.6% in early August, the highest reading since March. The 5-year ahead median inflation reading climbed from 2.7% in July to 3.0%. The Fed monitors market- and survey-based measures of inflation expectations and despite a benign July CPI reading on Wednesday, dealers see reasons for concern.
Economists at RBS Securities remarked Friday that inflation expectations, as well as concerns about the job market, led to a small drop in the expectations component of consumer sentiment. “Despite the improvement in buying attitudes, consumers were wary of rising prices. The report noted that the spike in inflation expectations was due to the drought’s impact on food prices. This may be a case where the recent headlines highlighting the surge in the cost of several food commodities is leading to fears of inflation even as actual price changes at the grocery stores remain relatively subdued. Indeed, the food index in the CPI inched up by only 0.1% in July and was up by just 2.3% on a year-over-year basis.”
The details of the July CPI report were number five on the top 10 major economic themes of the past week according to Bank of America Merrill Lynch US Economics, who felt the flat headline “keeps the QE door ajar.” BoAML wrote, “We believe there is upside risk to food price inflation later this year, as the impact from the drought makes its way into prices consumers pay at the grocery store. Fed officials will likely look through a temporary jump in food prices when assessing whether to ease further, provided inflation expectations remain relatively well behaved. Softer inflation but somewhat better activity data makes more QE at the upcoming September Fed policy meeting a very close call. At the very least, we would expect Fed officials to push out their ‘forward guidance’ and commit to not begin hiking interest rates until late 2015 at the earliest.”
While confident that a modest rebound in GDP growth in Q3 is in the offing, the Market Strategy Americas team at Barclays Research wrote Friday, “The likelihood of stronger inflation in August provides a potential headwind. Energy and food inflation are likely to pick up in August and September, and we expect core CPI inflation to rebound as well.” BarCap estimates CPI inflation will run at 1.7% y/y in the third quarter but rise to 2.1% in the fourth quarter. In the core measure, the dealer expects CPI to climb from 2.1% in Q3 to 2.3% in Q4. It sees the average core CPI rate in 2013 to be an elevated 2.5%. “The heavily weighted and less volatile components of core services (particularly owners’ equivalent rent) will underpin a steady rise in core inflation on a y/y basis during H2 12 and 2013.” In its summary of views, BarCap strategists recommended that investors be “long the Apr17-Feb42 breakeven flattener as the 5-year concession unwinds and as the long end has overreacted to economic data. Be long front-end breakevens energy hedged; take profits on Apr17s versus Jan17s. TIPS ASW (in a foreign basis) look attractive for CAD and AUD investors.”
In their U.S. Economics Weekly, Citi Research Economics drew the link between inflation soundings and monetary policy and wrote, “Leading up to the upcoming [Jackson Hole symposium] speech, policymakers have informally set several conditions that could trigger stepped up accommodation. They have focused on the issue of economic momentum and progress on unemployment as well as watching for signs that downside risks are increasing and indications that inflation may fall persistently below 2%. In 2010, core inflation was running below 1% and the prescription was QE2. Last year, although disinflation had ceased, inflation expectations were declining and the prescription was a less aggressive Operation Twist. Unlike the past couple of years, there isn’t a compelling story on any of these [dual mandate] fronts but there are legitimate arguments that the balance of risks is tilted unfavorably across the board.”
Economists at UBS Investment Research are downplaying the medium and long-term effects of energy soft commodity price increases. “The drought has sent the farm price of corn up about 40% since early June. While we expect a modest pickup in the rate of increase in food prices in the CPI over the next year, we do not believe the recent spike in the price of grain and related foodstuff prices poses much upside risk to our overall CPI forecast. Our CPI forecast includes a 2¾% y/y rise in food prices in 2012 and 3½% in 2013. Food prices account for about 14% of the CPI, so a 0.75-point acceleration adds just 0.1-point to overall inflation in 2013. We continue to forecast a 2.0% y/y rise in the CPI in 2012 and 1.9% y/y in 2013. The key to whether higher commodity costs lead to broad and sustained inflation pressures is whether they trigger higher inflation expectations. During the last major drought in 1988, inflation expectations temporarily picked up but settled back down after the drought ended.”
A benign outturn in July consumer prices surprised markets but dealers seem less sanguine about inflation expectations in the current month or for the balance of the year. Higher consumer expenditures and pipeline inflation pressures appear to be sufficient reason for the Fed to abstain from additional policy accommodation at least at the September 12-13 FOMC meeting. Dealers are now tasked with trying to determine whether the shift in the balance of risks justifies a pull forward in the timetable for removing policy accommodation.