Are Fears of Inflation Getting Ahead of Themselves?

Oct 22, 2021 | Nick Scholte


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For reasons cited herein, this appears to be the case.

To my clients:

It was an up week for North American stock markets with the Canadian TSX finishing up 1.4%; the U.S. Dow Jones Index finishing up 1.1%; and the U.S. S&P 500 finishing up 1.7%.

Though the Federal Reserve has yet to formally announce its plans for curtailing monthly asset purchases (in other words, begin winding down the latest iteration of quantitative easing), it’s widely expected that this decision will be made at its upcoming November 3rd meeting. Since the market already expects this occurrence, I really don’t think the announcement, when it comes, will have much of an impact upon equity markets. More importantly though is what comes next. The market is already looking beyond the tapering process to what the next interest rate hike cycle might look like and when it might start.

The bond market is now priced for approximately two rate hikes of 0.25 percent each by the end of next year (whereas just one month ago it didn’t expect any), followed by a further two hikes in 2023. The Fed, for its part, signaled at its September meeting that it is divided on the likelihood of even one hike next year. Further, the Fed’s expected endpoint remains below market expectations. The phenomenon of markets pulling forward the timing of expected rate hikes isn’t exclusive to the United States; the same dynamic has emerged in many other developed market economies. The most intense action has so far been in the UK, where RBC Capital Markets now expects the Bank of England to begin raising rates as early as this December, rather than in mid-2022 as previously expected. It appears that the need to tame inflation concerns via higher interest rates is driving these expectations.

However, as yet there are few signs that higher long-term inflation might be a problem. For example, in the U.S., the Federal Reserve Bank of Cleveland splits Consumer Price Index data into two categories: i) “flexible” prices—those more sensitive to economic factors, such as motor fuel, car rental, natural gas, used cars, and hotels; and ii) “sticky” prices – prices that are more stable and more sensitive to inflation expectations, such as apparel, rents, communication, and medical care services. It’s the sticky bucket that tends to attract the attention of central banks and, so far, sticky prices remain stuck in low gear. Currently, the Cleveland Fed’s index of sticky prices is rising at a pace of 2.7 percent y/y, compared to a 14 percent y/y rate of increase for flexible prices. The same dynamic can be seen in consumer data. The University of Michigan Survey of Consumers showed one-year inflation expectations rising to a decade-high 4.8 percent this month, while long-term inflation expectations remain anchored at just 2.8 percent, roughly equal to the average over the past 10 years. In other words, these data metrics continue to point toward inflation pressure being transitory.

Of course, there is also the chart I attached in the September 24th update (see here) which showed that the 2-year average of inflation (factoring in both the deflationary pressures seen early in the pandemic and the higher current – and possible temporary – pressures we are experiencing now) is broadly in line with the long-term historical average.

The point being that although inflation continues to dominate economic and investor sentiment, it seems that these concerns continue to be premature. That said, it’s a situation that will continue to bear careful scrutiny, and I will be watching.

Last note – weekly jobless claims fell yet again to a new pandemic era low of just 290,000. The trend in weekly jobless claims is one of RBC’s most carefully tracked recession indicators. It currently :indicates” that recession is a very remote concern.

That’s it for this week. All the best,

Nick

Nick Scholte, CIM, FCSI

Vice-President & Portfolio Manager

Scholte Wealth Management
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