• The second quarter has proven calmer for financial markets relative to Q1
  • The April CPI report showed the biggest monthly gain in core prices since 1981, driven by large increases in prices for used cars, airfare, and lodging
  • The “transitory vs. sustained” inflation debate persists in the economist community; wage inflation and consumer inflation expectations are worth monitoring for signs of sustained inflation pressures

The second quarter has been relatively tranquil for financial markets thus far versus what was experienced in the first three months of 2021, apart from ever-volatile crypto-currencies. Treasury yields have settled in a tighter range, perhaps desensitized by a Fed steadfast in its commitment to current policies and adamant that inflation is not a concern. The U.S. economic recovery has been robust, and the phrase “supply-chain bottlenecks” has become popular jargon to characterize obstacles amid the reopening effort. On the fiscal front, the White House and Congressional leaders continue to negotiate the Biden administration’s infrastructure spending plan, including both the scale and funding source (tax hikes), and late last week, President Biden’s ambitious budget proposal was released, calling for $6 trillion of federal spending in 2022. The White House budget proposal is closely aligned with the current push for spending on infrastructure, public health, and education. It also calls for increased taxes on corporations and wealthy individuals. Critics of the current spending initiatives worry that it further fuels inflation risks given already-strong economic fundamentals and Fed support. Fiscal budgets are still controlled by Congress, and with slim Democrat majorities in both the House and Senate, the tax proposals are already meeting resistance from both Republicans and moderate Democrats, the latter of which are worried about the potential impact on 2022 midterm elections according to media reports.

The Inflation Debate Continues

An inflation debate has captured the economist community for much of 2021, and the April CPI report provided additional fodder for both sides of the argument. The Fed remains firmly entrenched in the “inflation will be transitory” camp, suggesting that any 2021 price increases will be driven by temporary supply bottlenecks as the global economy reopens from the pandemic, but critics contend that the price increases will be stickier than Fed leaders and other inflation doves currently expect.

Core CPI surged 0.9% m/m in April versus expectations of a 0.3% gain. This was the biggest monthly increase in core prices since 1981 and triple the long-run historical average. April was expected to show price increases, but more of the focus was on year-over-year comparisons to the low point a year ago (base effect). Core CPI rose 3% y/y in April, 70 basis points (bps) more than expected, but to be clear, the huge month-over-month figure had nothing to do with the base effect. That said, the monthly price increases did exhibit signs of transitory factors. Roughly half of the April increase in core CPI was attributable to price gains for used vehicles, airfares, and lodging. Vehicle prices have been heavily impacted by supply chain disruptions, and airfares and lodging prices soared 10.2% and 7.6%, respectively. The latter is undoubtedly a metric of increased travel behaviors as Covid moves more toward the rear-view mirror; however, Exhibit 1 provides added context to the larger inflation debate. Despite the big monthly gains, both categories remain well below pre-Covid levels.

The market has largely faded the initial inflation worries following the release of the April CPI report on May 12. Long-end Treasury yields fell 8-13 bps over the remainder of the month, and both 5-year and 10-year TIPS breakeven yields moved lower as well.  The transitory argument essentially contends that supply chain disruptions will eventually be resolved, and the initial rebound surge in travel, leisure, and other sectors more heavily impacted by Covid will eventually level off.  Robust consumer spending in recent months has been fueled by a glut of fiscal stimulus and direct payments. Once that spigot is turned off, future consumption growth will be fueled by more typical sources such as income growth and sustained above-average wage growth would more likely lead to stickier price gains in aggregate. In a recent interview with the Financial Times, St. Louis Fed President Jim Bullard suggested that labor markets are tighter than they appear, pointing to anecdotal reports of worker shortages in some sectors requiring wage hikes to fill positions. If wage inflation becomes more prevalent, the camp of inflation hawks will undoubtedly expand.

Another aspect of this debate worth monitoring is consumer inflation expectations, something Fed leaders watch closely. The University of Michigan consumer survey tracks one-year ahead and 5+ year inflation expectations, and the median figures for both came in above expectations in May and are now at the high-end of the historical range over the last few decades, although still well below early 1980s levels (see Exhibit 2). Fed leaders have made it clear that they’re willing to allow inflation run hot in the near-term, particularly more transitory components, but a persistent rise in consumer expectations for future price increases could alter their plans.

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