Inflation has become a major focus, impacting economic activity, consumer data, and market prices. While it is not possible to predict the exact level of future price growth, we can examine prior and current inflation data to determine the likelihood that the current growth rate is sustainable. We can also look at market-based indicators to determine how investors are pricing in possible future outcomes.
In the month of April, two of the measures of consumer prices slowed on a year-over-year rate of change basis. The headline Consumer Price Index (CPI) increased 8.2% year-over-year in April, down from the 8.6% pace in March. The Personal Consumption Expenditure Index (PCE) increased by 6.3% year-over-year in April, down from the 6.6% pace in March.
Source: U.S. Bureau of Labor Statistics.
Source: U.S. Bureau of Economic Analysis.
Both measures of consumer prices also showed a widening gap between commodity prices and other goods and services. The Core CPI increased by 6.1% year-over-year in April (down from 6.4%) leading to a 2.1% spread between the headline and core measure. In April of 2021, that spread was 1.2% and at the end of 2021 it was 1.6%. The Core PCE measure increased 4.9% year-over-year in April (down from 5.20% in March) leading to a spread of 1.4%. In April 2021, that spread was 0.50% and at the end of 2021 it was 0.90%.
Source: U.S. Bureau of Labor Statistics.
Source: U.S. Bureau of Economic Analysis.
The CPI measures are in the first period where the year-over-year comparisons get more difficult. The year-over-year growth rate in 2021 went from 2.7% in March, to 4.2% in April, 4.9% in May, and 5.3% in June. This means that the current price measures will have to continue to increase by an even larger amount in May and June in order just maintain the same year-over year-level (and by even more for the year-over-year level to continue to increase). The comparison set stays the same from July until September and then accelerates in the fourth quarter as the year-over-year increase in October 2021 was 6.2% and rose to 7.1% in December. The core measure follows a similar path, rising from 1.7% in March 2021 to 4.4% in June and from 4.6% in October to 5.5% in December. The PCE and Core PCE are similar, just with lower absolute numbers.
This does not mean that consumer price measures cannot continue to increase in the coming months, it just lowers the probability of that occurring as the difficult comparison level rises. Commodity prices could continue to increase on an absolute level (keeping the absolute level of inflation high), but they also face more difficult comparisons over the course of 2022, lowering the probability that the rate of change for their growth rate continues to increase.
Source: Koyfin.
The above analysis shows where inflation measures have been and where they are now, which helps determine the probability or likelihood of the current growth rate moving higher, lower, or staying the same. There are some market-based indicators that can provide insight into how investors are viewing where inflation measures may be in the future.
One of those measures is Treasury rates. These securities should be priced based on expectations for future economic growth and inflation. The directionality of interest moves, the shape of yield curves, and the absolute level of interest rates should reflect how investors are pricing the movement and level of the future state of the economy (including inflation).
During the month of May, two-year to thirty-year interest rates declined, even with the Federal Reserve increasing the Federal Funds target range by 50bps. Two-year rates dropped by 30bps from their May high, with the drop increasing up to ten-year rates, which declined by 40bps. Thirty-year rates only declined by 26bps. Much of the recent decline in interest rates could be related to a view by investors that the outlook for economic growth is weakening and the Federal Reserve may not increase interest rates at the pace that they have been guiding towards. At the same time, some of the decrease in longer-term rates should be related to a decreased outlook in the growth rate of inflation, as ten and thirty-year rates are less impacted by movements in the Federal Funds rate, and the decline in rates took place during a period when oil/commodities were increasing.
Source: Macrobond.
The larger decline in five to ten-year rates compared to thirty-year rates can also be seen in the shape of the yield curve. The intermediate measures like the five-two year, ten-two year, and the ten-five year flattened from their May highs and are close to where they started the month. The ten-year also went back below the seven-year after briefly going above.
Source: Macrobond.
The yield curve on the long end (30-year) steepened during the month of May, which was a reversal from the pattern earlier in 2022. This also shows that some of the decline in interest rates has been driven by investors expecting fewer interest rate hikes, again, likely a combination of weaker economic growth and the growth rate of inflation slowing.
Source: Macrobond.
The market-based measures of inflation also reflect investor expectations for the growth rate of inflation to slow. Five-year inflation breakeven rates peaked in early March above 3.5% and declined to below 3% in May. The breakeven curve remains inverted, with shorter term measures of inflation higher than longer term (shorter term being more sensitive to spikes in prices) but has started to normalize. The spread between ten and five-year breakeven rates also continued to narrow, from a low of -65bps to -32bps.
Source: Macrobond.
Based on the comparison set getting more difficult in 2022 and the market-based indicators starting to price in a weaker economic environment, the probability is increasing that the growth rate of inflation will stop accelerating in the coming months and may decelerate in the second half of the year and into 2023.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Senior Vice President, Investment Strategy
Boyd Watterson Asset Management, LLC