Last week’s US inflation surprise reignited concerns that the inflation pick up is not transitory but rather, it is here to stay.

In April, year-on-year inflation growth in the US stood at 4.2% compared to the previous level of 2.6%, and above market consensus of 3.6%. The strongest pick up in prices was recorded across the energy segment, used cars and trucks, followed by transportation services and rent prices within the shelter category. The core inflation number, which excludes the price change across food and energy prices, also surprised to the upside, at the 3% level, compared to the expected 2.3% increase.

The strong spike in inflation numbers can be attributed to various factors. Intrinsically, year-on-year change in prices are capturing the sudden and strong plunge in prices at the start of the pandemic. Mathematically speaking, the rise in inflation can be partially attributed to base effects. This is particularly evident across the higher prices across airline fares, which increased close to 10% on a yearly basis and the impact on fuel oil and gasoline prices as the commodity market rallied. While the base effect impact is undeniable, supply chain disruptions as well as temporary shortages, such as the shortage of chips in the auto industry, are also key contributors to the rise in prices. This is also captured in the 21% increase in prices for used cars and trucks, as supply of new vehicles remains constrained.

On this basis, the spike in inflation numbers is expected to be transitory. This view is in line with the current stance across central bankers. US Fed Chair Jerome Powell has made it abundantly clear that despite the strengthening recovery and stronger accommodative fiscal stimulus, the Fed remains tolerant towards transitory rise in inflation. This implies that the temporary spike in inflation numbers will not be enough to trigger tightening, and reference to tapering talks was deemed as premature.

While this may be true, the extent of fiscal support and pent-up savings in the economy, poses a key risk that inflation continues to surprise to the upside as the economy reopens. Keeping in mind the Federal Reserve’s dual mandate of achieving price stability and maximum sustainable employment, the following are key data points to track for monitoring inflation and implicitly, any changes in monetary policy expectations.

Inherently, inflation expectations matter. Break even inflation rates are market’s measure for inflation expectations. Currently, the US five year break-even rate stands 19% higher since the start of the year, at the 2.3% level. Relatively speaking, while the growth in inflation expectations were 31% higher in Europe, Germany’s 10-year break even rate is still at the 1.6% and far below the bullish inflation expectations in the US. Longer time horizons in breakeven rates also follow the same trend, as inflation expectations continued to strengthen over the past months. Ironically, the Federal Reserve’s average inflation targeting approach, that will allow inflation to temporary overshoot, could lead to long-term inflation expectations to go even higher.

Meanwhile, substantial progress is also required across the US labour market, including achieving broader and inclusive maximum employment goal. On the one hand, the number of new claims for unemployment benefits continues to trend lower, as the economy reopens. However, the US unemployment rate as at April rose to 6.1% and above market expectations of 5.8%, as labour participation rate increased from 61.5% to 61.7%. The latter still remains 1.6% points lower than pre-pandemic levels, reminding us that labour market slack remains. The pace at which the labour market recovers in the coming months, remains a key measure to gauge progress towards the Fed’s goal of maximum employment.

Moreover, actual inflationary pressures are unlikely to materialise unless labour market conditions tighten sharply and push wage inflation higher. So far, the rise in average hourly earnings albeit unexpected, are still marginal. Average hourly earnings increased by 0.7% in April, following a 0.1% decrease in March. Any overshoot on the wage growth front would also lead to more persistent inflationary pressures.

Ultimately, while further inflation spikes and market volatility are expected in the coming months, investors must remain focused on the key data points which not only point to a temporary spike in inflation but also support higher inflation expectations in the longer term.

Disclaimer:

This article was written by Rachel Meilak, CFA, Equity Analyst at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd which is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

For more information visit https://cc.com.mt/ The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.