We have pondered earlier if inflation was indeed the joker in the pack that could potentially restrain the Fed's rate-cutting spree. Certainly inflation fears did not prevent the Fed from lowering the benchmark Fed funds rate by a whopping 225 bps in just six months. But this week's data will certainly force the Fed to rethink the magnitude and pace of subsequent rate cuts.
The Bureau of Labor Statistics reported this week that seasonally adjusted consumer price index jumped up 0.4% in January and is up 4.3% over the past 12 months, near a 16-year high. This is a sharp jump from the 2% reading in August, despite the economy slowing significantly in the fourth quarter. Even after stripping out surging food and energy costs - the Fed's preferred so-called 'core' inflation – prices rose 0.3% in January, up 2.5% from the prior year, a 10-month high. This was the biggest seasonally adjusted one-month jump in core CPI in 19 months.
This should not have come as a complete surprise at all. Crude oil crossed the much-watched $100 mark this week, much to the chagrin of pundits on Wall Street. Gains in prices of industrial materials and higher prices of grains, soybeans and other soft commodities pushed the CRB index to near record highs this week. Gold surged by another $40 this week to a phenomenal $948; not to be left behind, other precious metals have seen similar jumps over the past few weeks. Bond traders had certainly seen the future early, having pushed the yield at the long end of the curve almost 50 bps over the last few weeks.
A simultaneous rise in unemployment and inflation, coupled with dwindling growth has the market wondering whether we are headed for 'stagflation' - a period of rising inflation despite slowing or stagnant growth. Stagflation, a term coined by British Parliamentarian Iain Macleod in 1965, came to define the US economy between 1970-1981. The economy suffered three recessions in that period, with inflation soaring to 15% and unemployment rising to 9%. It took a very severe hand from the toughest of central bankers, Paul Volcker, to finally conquer inflation by dramatically raising interest rates. The monetary tightening did have its repercussions, leading to a severe recession in 1981-82.
The seeds of the 1970s stagflationary phase were actually planted in the late 1960s, when President Johnson spurred growth by the frantic spending on the Vietnam war, helped by a complying Fed which failed to sufficiently rein in that growth. Things came to a head in the early 1970s when the Arab oil embargo dramatically drove up oil prices and overall inflation levels. President Nixon, in conjunction with the then Federal Reserve Chairman, Arthur Burns tried to rein in inflation by raising rates and imposing controls on wage and price increases. However, despite pushing the economy into a severe recession in 1974-75, inflation and unemployment failed to revert back to the levels of the previous decade. Political pressure finally led to the stepping down of Burns in 1978.
Stagflation is a scary word for most economists; it is almost the sum of all fears. Having said that, as with anything that scary, fears of stagflation have actually been more common than instances of actual stagflation. The beginnings of the past two recessions (1990-91 and 2001) have typically seen a brief rise in inflation, that subsequently trended down as unemployment kept rising. The current situation, although carrying a similar title, differs significantly in its contents. Sure, the current pace of inflation is a problem. In a speech in June 2006, Bernanke indicated that core inflation, then running at 3.2% over the prior three months and 2.8% over the prior six months, was at the upper end of his tolerance level. The 3-month and 6-month core CPI now works to 3.1% and 2.7% respectively, just shy of what Bernanke had deemed to be too high. Either we have reached the limit of what the (current) Fed has been willing to tolerate in recent years, or else they have moved the bar.
It is important to note that a persistent escalation of inflation would occur only if workers and the firms that employ them come to expect the elevated inflation to persist into the future and set their wages and prices accordingly. Expected inflation is an important determinant of future inflation. If the public expects higher inflation, workers demand higher wages, prompting employers to raise the price of their goods, which results in higher actual inflation.
Fixed-income securities markets usually provide timely information about inflation expectations. The expected inflation rate - implied by the gap between the yield on 10-year nominal Treasury bonds and that on bonds whose coupons and principal are indexed to rise with CPI (TIPS) – has remained largely unchanged over the last year. Further, the median consumer expectations of price change over the next 12 months, as indicated by the University of Michigan survey, has risen modestly over the past few months but remains well short of danger territory.
Spread between yields on 10-year Treasuries & Treasury Inflation-Protected Securities (TIPS) of similar maturities.
University of Michigan consumer survey of inflationary expectations
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