February CPI Paints a Docile Inflation Picture
Investors and the Fed are expecting a pop in inflation shortly from another round of stimulus hitting the economy, as well as continuing improvement in the pandemic, and distressed values from March and April last year rolling out of the YoY calculation. Alas, February CPI arrives as something of a placeholder until the above have a chance to work more fully on the numbers. In any event, overall CPI rose 0.4% matching expectations and up a tenth from January. Increased gas prices accounted for most of the gain. Core CPI rose 0.1% after being unchanged the prior month. Expectations were for a 0.2% gain. YoY CPI did move to 1.7% versus 1.4% in January but core CPI dipped a tenth to 1.3% YoY. The bigger moves in inflation will have to wait another month or two, but even then the Fed expects them to be temporary. We discuss the inflation issue further in the next section. Finally, in our latest podcast we sit down with Steven Schnall, CEO of Quontic Bank. Listen as Steven tells how he took a small, sleepy Queens-based bank and transformed it into a digital financial institution which does business in all 50 states by embracing the digital revolution and promoting a culture of innovation. The iTunes link can be found here and the Spotify link here.
It’s not news to most market watchers that much of the upward thrust in nominal Treasury yields has been the relentless push higher in inflation expectations. Those expectations are driven by outsized growth expectations as the economy comes out from under much of the pandemic restrictions, super accommodative monetary policy, and record-breaking fiscal stimulus. What is interesting is the front-loaded nature of those inflation expectations and it makes intuitive sense. The graph below tracks the difference between 5Yr TIPS breakeven inflation rates and 10Yr TIPS breakeven inflation rates. As shown, the 5Yr expectation is at a record spread to the 10Yr in data that goes back to 2002. The 5Yr TIPS inflation rate is 2.45% while the 10Yr is at 2.22%. The 5Yr rate is at a 13-year high.
TIPS investors think the push higher in inflation will occur more over the short to intermediate term and not be a long-lived phenomena. Given the expected economic rebound off pandemic-inspired shutdowns, and the historic fiscal stimulus, that seems a reasonable bet. Recent Fed speakers have said as much in that the expected near-term bump in inflation is likely to be temporary in nature with longer-run inflation pressures more a factor of the labor market rebounding along with wage gains. The bottom line is while the Fed and the market expect near-term price pressures they don’t see the conditions yet for a durable move higher.
Labor Market Still Has A Big Hole To Dig Out Of
One reason the Fed has been adamant that easy monetary policy will be in place for quite some time is the damage done to the labor market by the pandemic that is somewhat unique compared to other recessions. Given the early lockdowns, school closings, and other social restrictions millions of formerly employed persons have left the labor force in the last year. That is they are not working and not looking for work. A large contingent in that group is the 55 and over cohort that decided to either retire early, or at least move away from being in a traditional work environment. Another large group are previously working mothers now homebound due to children in virtual school settings. Much of that group is likely to return to the labor force once schools reopen in numbers, but not all.
The above graph shows the year over year percentage change in the labor force and the damage inflicted by the pandemic. Nearly 10 million people remain unemployed from the initial peak of 22 million but another 4 to 5 million left the labor force in the last year as well. That shrinking of the labor force has been historic. Some of those former workers will return to the labor force but many will not. Also, looking at the graph you can see just prior to the pandemic labor force growth was averaging around 1% per year. With this low organic growth rate you can see why the Fed expects the labor market healing to be a multi-year process. While investors have moved forward expectations of the Fed’s first rate hike into 2022, the Fed has been adamant about getting back to maximum employment, and repairing the labor force decline will be a big part of that. We think that as long as inflation hovers just over 2%-2.5%, which TIPS projections point to, the Fed will continue to be patient and wait for more labor market healing before even considering hiking the fed funds rate.
Agency Indications — FNMA / FHLMC Callable Rates
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