Central bank

Inflation tests Fed’s patience again

14 July 2021 • 4 mins read
  • June’s consumer price index (CPI) again beat expectations with headline and core prices surging by 0.9%MoM each to yield inflation rates of 5.4%YoY and 4.5%YoY respectively.
  • Excluding volatile food and energy costs, core inflation is now at its highest level since 1991 and well above the Federal Reserve’s 2% goal.
  • But the Fed is still likely to see the sharp summer increases in inflation as being only transitory as the US economy reopens and will thus will stay dovish to the benefit of risk assets.
  • We expect the Fed will discuss when to taper quantitative easing at its July and September meetings but will wait until December before deciding to slow its bond buying from January.

June’s consumer price index (CPI) was stronger-than-expected for the fourth month in a row, increasing fears that rising inflation will require the Federal Reserve to start tapering its quantitative easing this year to the detriment of risk assets.

Headline and core prices excluding volatile food and energy costs both surged by 0.9%MoM, yielding inflation rates of 5.4%YoY and 4.5%YoY respectively, the highest levels since 2008 and 1991 and well above the Fed’s 2% target. The central bank, however, is still likely to view the increases in inflation being only transitory as the US economy reopens and thus will not respond by starting to taper its bond buying in 2021.

First, June’s inflation pop was again driven by outsized increases in goods prices due to supply shortages that are likely to be resolved in the next few months or because of strong reopening demand for services that is also likely to ease as activity returns to pre-pandemic levels.

For example, used car prices jumped by another 10.5%MoM and new cars increased by 2.0%MoM as the global shortage of semiconductors hinders production. Retail used car prices have thus increased by 29% this year but wholesale prices for used cars have already started to moderate. Similarly, hotels and other lodging costs away from home surged by 7.0%MoM and airline fares rose by 2.7%MoM. But lodging prices are now higher than the start of last year, implying further upside here in lodging costs may be limited.

Source: Bank of Singapore, Bloomberg.

Fed officials will note that June’s increases in new cars, used cars, lodging costs and airline fares accounted for almost all the 0.9%MoM increase in core CPI last month, reinforcing the central bank’s view that the sharp summer increases in inflation above its 2% target are likely to be only temporary. After June’s CPI data was released overnight, San Francisco Fed President Daly said: ‘I really do see this as temporary, the used cars really being a good example.’

Second, despite the near-term increases in inflation as the economy reopens, long-term inflation expectations continue to be stable around the Fed’s 2% target. For example, 10Y breakeven rates are currently at 2.38% only.

Fed policymakers will keep watching the inflation data as not all the increase in June’s prices were due to temporary, cyclical factors. The chart shows owners’ equivalent rent (OER), a more persistent source of inflation in the economy, rose by 0.3%MoM and 2.3%YoY. But a sudden, hawkish shift in the Fed’s patient outlook still seems unlikely as officials will want to see how inflation evolves over the next few months as the economy reopens, whether the new delta variant spreads further and if the labour market continues to recover from the pandemic. We thus expect the Fed will still be slow to taper quantitative easing, discussing the timing at its July and September meetings but only announcing in December that its bond buying will start being reduced from January next year.

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