USCPI,inflationexpectationsandverbalintervention

Before the holiday yesterday we had written that how the world awaits the US inflation print. The headline CPI data for the month of April came at 4.2% against the expectation of 3.6%. Fed in its mandate follows the measure of PCE to anchor it around the 2% level and not the headline CPI. There are multiple inflation gauges which float around, there is a PCE, a CPI (CPI-W and CPI-U), a PPI, a GVA. Then there is a core element of PCE and CPI. Fed monitors the Core PCE. Core is without the impact of food and energy prices. Generally, core is preferred by the policy makers over the headline number because of it being seen as more structural and less impacted by the vagaries of more volatile components like food and oil prices which are deemed beyond the scope of monetary action. A drought here and a missile fire there can induce substantial changes in the prices of energy and food items. An interest rate cut, or hike can hardly influence the phenomenon.

As we had written previously the markets hardly have time to sieve through such nuances and frankly, they are interested in direction. If it is up, it is up, whether PCE, CPI, GVA or WPI is up hardly matters. That is for the commentators to intellectualise later. The knee jerk reaction of the data print was understandable. Equities fell, yields went up and the Dollar strengthened. This chain of causation we have explained multiple times in past but given that we are prone to verbiage anyways we will do it again. High inflation means quicker normalization of policy rates (read hikes), cost of capital for companies goes up (Stocks down), bond yields start pricing in the hikes, Dollar gains strength as it is the safe asset and some of the carry trades see reversal.

Now the Fed in all its communication has been saying that the inflation even if it comes will be “transitory” in nature. It will pass. Any news on inflation hence pits the markets up against this definition of “transitory”. Let us see what transitory alludes to. It means the number because it is not an absolute number but a percentage, will be impacted by the denominator (base effect). It can also be because there are some supply bottlenecks somewhere which will get ironed out once the economy reopens fully. Here readers should note that why this constant communication from Fed playing down any high inflation reading is important. In a slightly technical language, it is a sort of verbal intervention strategy. One should be aware that irrespective of what is the inflation level today the more important thing is that what do you expect inflation going forward. If you believe that inflation is going to run faster than your ability to negotiate wages, the future will make you progressively poorer in real terms (remember GOT; winter is coming!). Any such thought would impact your decision to consume that purchasing power while it is with you. You will prepone the purchase, driving the prices up. This is called inflationary spiral. So, managing the inflation expectations is a key task for any policy maker.

Markets however are not a static observer of what only Fed says or what the inflation print is. It keeps tracking a myriad of news like retail sales, sales of both durable and non-durable goods, wage increases, jobless claims, housing price indices etc to gain insight on whether inflation is transitory or structural. It expresses itself by providing liquidity in the Fed funds futures markets where one can bet on when they see the hike happening. Readers would do well to note that just because the market has given the price it doesn’t mean the future turned out that way. During the entire last decade at every point of time Fed futures kept indicating a hike which eventually came in 2016. In our future notes we will take up in detail the relationship between jobs and inflation.