In the week just past, the choppy price action in the treasury market has contributed further to the evolving macro narrative.
The Thematic Flattening
Over the last week, one important macro narrative was the stronger than expected headline and core CPI print. In fact, inflation is now running at the highest levels that it has both on the headline and the core series since the early 1990s, which intuitively brings into question the Fed’s expectations for prices to eventually moderate and also leaves the market focused on the pace of tapering. Will the Fed accelerate the pace of bond buying, which will create the needed flexibility to bring forward the liftoff rate hike into the middle of 2022 compared to the previously assumed Q4? So does the October inflation print warrant recalibrating Fed expectations for the year ahead? The higher-than-expected CPI certainly puts Q4 2021 on a reflationary trajectory causing the market to reinforce its notion that the flattening of the curve will keep being thematic in 2022. However, my take is that still, there will be plenty of data between now and the point where the Fed actually needs to make the decision on liftoff.
A Breakdown of The October Inflation
As part of this discussion, there’s also the critical component of the details within the CPI release. When looking at the breakdown of the inflation, what we see is that there is arguably a broadening of the categories of upward pressure on consumer prices. The surprise was not solely a function of some pandemic-specific increases in prices, i.e., airfares, lodging away from home, subcategories simply related to the lifting of restrictions and reengaging in some version of a normal economy. Rather, we saw that energy was intuitively up sharply, and even within the core series, the new and used auto prices continue to support inflation expectations and probably most noteworthy, a sharp 0.44% month over month increase in OER or owner’s equivalent rent.
Now this is not necessarily a surprise, given what we’ve seen in the real estate market over the last 12/18 months (history suggests there’s a lag between housing prices and rent increases by roughly five quarters i.e., rents are “sticky”). But the fact that it’s now flowing through with a meaningful effect on the core CPI series, has to raise some questions on the FOMC. The interesting part is that Powell has come out in the past and said that the Fed is not worried about the run up that we have seen in home price appreciation. Now, that isn’t to suggest that there’s no chance that the Fed would ultimately feel compelled to respond to inflation, even if it was driven in part by the recent acceleration in home prices, as evidenced by OER, but here’s a very compelling argument that what drove the increase in home prices was 100% the pandemic and the Fed’s response. Not very obviously that this can be the natural result of reopenings and the new normal coming back online. It’s effectively saying that the Fed’s policy response, i.e., much lower rates combined with the exodus from densely populated urban centers to first and second ring suburbs is what’s truly driven home prices higher. Perhaps there’s an argument to be made that that’s a temporary impact or transitory.
Signs to Pay Attention
In the upcoming week’s heavy slate of Fed speak, it’s going to be very interesting to see the degree to which other monetary policy makers stick to that transitory characterization. As we get closer to that point in the cycle, any earlier tone shift from either Powell or frankly anyone else on the committee could potentially be a signal that monetary policy makers are thinking about either accelerating the pace of tapering or pondering maybe bringing the lift off rate hike forward, or making the first rate hike by more than 25 basis points.
All About Macros 