By Peter Jones, CFA
Senior Vice President
Markets sold off this week, and dramatically on Friday, as new inflation data showed price increases reaccelerated in May. This morning, the Bureau of Labor Statistics reported that the Consumer Price Index (CPI), which is the most well-known measure of inflation, increased 1.0% in the month of May and increased 8.6% compared to the year-ago period. This number marks a new 41-year high for inflation.
Beyond the erosion to consumer purchasing power associated with high levels of inflation, the news today increases the chances that the Federal Reserve is forced to choke off the current economic expansion by raising interest rates in a rapid fashion. Prior to this morning’s data, investors expected the Fed to raise interest rates by an additional 2.0% by the end of the year. Today, futures markets now imply that the Fed will raise by an additional 0.25%, and as a result, stocks declined another 3% on Friday.
While new CPI numbers certainly dent the argument that inflation has peaked, details within the data do suggest that inflation levels should moderate through the balance of the year. As mentioned previously, headline CPI increased by 8.6% compared to the year-ago period, an acceleration from 8.3% in April. However, “core” CPI, which excludes volatile food and energy categories, increased 6.0% which represents a deceleration from 6.2% last month and a peak of around 6.5% (chart below). Core CPI tends to be a better measure of the longer-term trend in inflation because its components are stickier than those driven by commodity prices. While 6.0% is still too high for the economy to absorb long term, the trend is moving in the right direction.
Source: Bureau of Labor Statistics
Future inflation expectations can be implied in the bond market. On this front, the outlook for inflation has improved compared to just a couple of months ago. As indicated in the chart below, one-year expectations have fallen by a full 1% down to 5.3% and 10-year expectations have fallen to a very manageable 2.8%. In other words, while today’s news is certainly a setback, the underlying components of inflation suggest that long-term inflation will be more benign than what was expected just 3 months ago.
Source: Bloomberg
While we acknowledge that inflation has remained at higher levels longer than we had anticipated, most importantly, this has not changed our forecast - that the economy will remain in expansion for the balance of 2022. Unemployment has fallen back to the levels we saw prior to the pandemic. Jobs available remain so plentiful that almost anyone that wants a job can find one. Deferred spending, stimulus checks, booming home prices and high levels of refinancing in 2021 have left consumers with substantial dry powder to absorb higher inflation in the near term. On the business front, corporate profit estimates for 2022 are higher than they were at the beginning of the year and are expected to increase 11% this year. While the action required from the Fed does pose a risk to the economy beyond this year, we remain confident that we will not see a recession this year.
Takeaways for the Week:
The consumer price index, the most followed measure of inflation, reached a 41-year high in May
Excluding volatile energy and food classifications, inflation peaked in March and decelerated further in May
Healthy consumer balance sheets and growing corporate profits provide us with confidence that there will be no recession in 2022