Inflation vs. the economy: Recent reports defy expectations for both

Vladimir Lenin once said, “There are decades where nothing happens; and there are weeks where decades happen.” That’s true of geopolitics, but I also think it can be applied to inflation. The last several weeks have been more like decades when it comes to inflation – both the perception and the reality.

A trio of concerning inflation indicators

In the U.S., market perceptions of inflation have changed due to recent data points suggesting inflation is more persistent than expected:

• It all started on Feb. 3 with the U.S. Employment Situation Report for January, which indicated that the economy was running hotter than expected. While wage growth wasn’t high, it ignited concerns that inflation could run hotter.
• Then on Feb. 14, the U.S. Consumer Price Index report showed that inflation moderated more slowly than expected last month.
• Finally, on Feb. 24, we got the January Personal Consumption Expenditures (PCE) report, which came in higher than expectations. PCE increased 0.6% month over month, which was above expectations of 0.5%, and 5.4% year over year, well above expectations of 5.0%.¹ Core PCE rose 0.6% month over month, higher than expectations of 0.4%, and 4.7% year over year.¹

The most concerning part of the PCE report was core services ex-housing, which rose 0.58% month over month — one of its most substantial monthly increases.¹ This component of inflation has become a major concern for the U.S. Federal Reserve (Fed) — in the February Federal Open Market Committee meeting minutes, participants articulated worries that inflation isn’t slowing enough in core services ex-housing, and that upward pressures on this component could continue because the labour market is very tight.

These data points changed market perceptions of inflation — and expectations for monetary policy tightening. Fed funds futures reflect this significant change: on Feb. 2, fed funds futures contracts indicated an expected terminal rate of 4.88% by August.² But after receiving this trio of inflation indicators, fed funds futures indicated a terminal rate by August of 5.4% as of Feb. 24.²

The U.S. economy seems stronger than many expected

But inflation isn’t the only area where perceptions are changing — recent data indicates that the U.S. economy is stronger than many expected.

It all started with that same January jobs report released on Feb. 3, showing far higher non-farm payrolls than expected. Other data points have corroborated the view that the U.S. economy is more resilient.

• S&P Global Flash U.S. Composite Purchasing Managers’ Index (PMI) for February moved back into expansion territory and is now at an eight-month high.³
• The Chicago Fed National Activity Index rose to 0.23 in January from -0.46 in December, helped by improvements in production-related indicators and employment-related indicators.⁴

In remarks last week, St. Louis Fed President James Bullard explained, “It kind of seems like the U.S. economy might be more resilient than markets thought, let’s say, six to eight weeks ago.”⁵

A double-edged sword: Inflation vs. growth

What we’re seeing is a double-edged sword: The U.S. economy is in better shape than we expected, but inflation is in worse shape than we expected. So what matters more? Right now, it seems the inflation data matters more given how laser-focused the Fed is on tamping down inflation. That’s why as of Feb. 2, the S&P 500 Index had risen more than 8% year-to-date as rates fell, driven by tech stocks that are very sensitive to rates.⁶ Since then, the S&P 500 has given back a lot of those gains as markets have anticipated a more hawkish Fed.

A similar situation in Europe

This phenomenon is not isolated to the United States. We are also seeing the same situation in the eurozone; the economy is stronger than expected — but so is inflation.

• Flash February S&P Global Composite PMI for the eurozone is well into expansion territory at 52.3, which is a nine-month high.⁷ Both components are expanding: eurozone manufacturing PMI clocked in at 50.4, also a 9-month high, while services is 53.0, an 8-month high.⁷
• While January euro area consumer price inflation eased from 9.2% to 8.6% year over year in January, core inflation actually accelerated to 5.3% from 5.2%,⁸ which is likely to be a cause of concern for the European Central Bank. Bundesbank President Joachim Nagel shared his view last week: “it would be a cardinal sin to let up too soon.”⁹

Making sense of these recent reports

So how do we make sense of this? I think this is likely a short-term phenomenon, with spending and prices heating up with unusually warm weather in colder parts of the U.S. and Europe. Downward pressure is likely to be exerted on both economic growth and prices, as the lagged effects of monetary policy tightening work their way through these economies. That doesn’t mean that growth and inflation will deteriorate quickly; I think it may be slower to moderate, but I expect it to ultimately move in the right direction.

A silver lining

The 10-year U.S. Treasury yield has risen back toward 4.00% rapidly over the last several weeks which, as I pointed out above, has exerted downward pressure on stocks.¹⁰ However, there may be a silver lining to be found in the higher 10-year yield.

As my colleague Paul Jackson pointed out, more than two-thirds of the gain has come from the “real” or inflation-adjusted component of the 10-year yield, which is represented by the Treasury Inflation-Protected Securities yield (the TIPS yield has moved from an early-February low of 1.15% to 1.58% last week).¹¹ According to Paul, this suggests the rise in 10-year yields has more to do with optimism about the economic cycle, rather than concerns about inflation.

Conclusion

So markets are currently pricing in additional rate hikes and a further tightening of financial conditions, and this could, of course, lead to a continued near-term retracement of previous gains. However, I don’t expect actual tightening to be dramatically higher than what was expected back in January. Ultimately, I expect inflation to moderate and the Fed to end its tightening cycle, creating an improved backdrop for risk assets.

However, it might be a bumpy road over the next several months before we get there, with more defensive components of the market performing better. But keep in mind that as quickly as sentiment changed over the last several weeks, it can change again. That’s life in a data dependent world. Buckle up and stay diversified.