Data published on 10 February 2022 showed the US consumer price index (CPI) rose by 7.5%, the fastest annual rise for 40 years. The increase in January’s index was above consensus expectations and slightly surpassed the previous 40-year high of 7% on an annual basis recorded in December.
On a monthly basis, consumer prices rose by 0.6 % from the previous month.
Analysing January US CPI data
Some, but not all elements of this CPI report give cause for concern as to the crucial question of whether US inflationary pressures are becoming more entrenched (less transitory), potentially triggering second-round effects. Here’s an analysis of the main elements in the January report:
- The pace of core inflation (excluding food and energy) was basically flat after two months of deceleration. Durable goods inflation, which is where inflationary pressure up until now has been most apparent, fell slightly. The pace of price rises for core non-durable goods (e.g. clothes, tobacco, cleaning products) slowed for the fourth straight month.
- As had been expected, rental inflation rose again slightly. Housing is by far the largest component in core CPI and a segment where inflation is often quite persistent from month to month: strength (or weakness) in one month’s data tends to be followed by further strength (or weakness). Having risen consistently in recent months, it is now approaching a 30-year high. Last year’s sharp increases in US house prices suggest it may continue to rise from here.
- Services inflation is now at a 30-year high. Thus far, a narrative whereby US inflationary pressures were primarily a function of continuing high demand for goods meeting disrupted supply chains was credible. Any sign that, as the economy reopens, services inflation accelerates, even if it is only slight as was the case in January, suggests inflationary pressures may be spreading to services where higher prices tend to be stickier.
Such concerns received sustenance from the Atlanta Fed’s index of historically ‘sticky’ prices. In January, this showed the single largest monthly move (4.3% to 7.5 %) since the start of the Pandemic. In addition, the Fed’s preferred measure of wages (wages being viewed as the main channel through which price increases spread, the employment cost index) was running at a 4.5% annual rate for wages and salaries through December 2021.
- More signs of rising wages came on 10 February from the Federal Reserve Bank of Atlanta, whose regional wage tracking data for January showed wage growth of above 5% for the first time in 20 years.
US bond market reacts strongly
There was a strong response in the Treasury market to this report. Before its release, the fed funds futures market priced the chance of a Fed rate rise of 0.5% in March at one in four. After the report, the probability rose to 90%. The futures market now prices a rise in the funds rate to almost 1.8 % by December (the rate is at close to zero currently).
Our fixed income team continues to expect the Fed to raise rates at every policy meeting this year and to continue in 2023 until policy rates reach 2.5% (considered to be the ‘neutral’ level of policy rates by the Fed).
Following the report’s publication, the yield of the 2-year Treasury note rose to almost 0.25% to reach 1.59%, the largest one-day rise of the Treasury note’s 2-year yield since 2009. In November 2021 it was trading around 0.40% and is now at its highest level since January 2020. The yield of the benchmark 10-year Treasury broke above the 2% level for the first time since August 2019. Finally, the yield of the US 30-year long bond rose less, but also made a multi-month high.
Comments in the wake of the CPI report from James Bullard, president of the Saint Louis Fed and a voting member of the policy-setting Federal Open Market Committee, may have exacerbated the market’s reaction. He said that he would like to see increases in official rates totalling 1% by July 1 — and that the FOMC should even consider an unscheduled meeting before March to start the tightening cycle (were this to happen, it would be the first intermeeting Fed rate rise since 1994).
The yield curve flattens
The US yield curve responded by flattening significantly with the 2-year bond taking the lead from the fed fund futures and pricing an additional rate increase almost immediately.
A flattening of the curve could imply the market is unconcerned about inflation risk longer term, perhaps because the Fed could tighten policy so abruptly as to cause a recession.
The gap between 2-year and 10-year US Treasury bond yields has fallen (i.e. the curve has flattened) from a high this cycle of 1.50%, to 1.20% in the spring of 2021, before reaching almost 0.40% today.
That is to say an inversion of the yield curve is approaching. When yields at the 2-year point on the yield curve exceed 10-year yields, it is generally taken as a signal that the market is reckoning with a recession, perhaps caused by overly abrupt tightening of monetary policy. For this reason, an inverted curve could give a central bank reason to slow the pace of any further tightening.
Stock markets fall
US stocks fell in the wake of the CPI report. The Nasdaq Composite closed down 2.1% and is off more than 9% year-to-date. The broad-based S&P 500 index closed down 1.8% and is off 5.5% this year.
Following in the wake of the US, European stock markets also fell on 11 February. The STOXX 600 index dropped by 1% in early trading. On account of their heavier weightings in commodities producers and bank stocks that tend to benefit from higher interest rates, European stocks have weathered the correction better so far this year. The STOXX is down by around 4% in 2022, while the UK’s FTSE 100 has risen by 3%.
Yesterday’s US CPI report gives further sustenance to the narrative that higher and more persistent inflation has caught US policymakers off guard. A major shift in market expectations for US monetary policy is underway. Our fixed income team believes monetary policy to be overly accommodative. It expects the Federal Reserve will raise policy rates to at least 2.5% by mid-2023.