Hello Inflation, My Old Friend - Here to Stay, or Merely Visiting?

This week’s macroeconomic news was dominated by the debate over U.S. inflation. Both consumer retail inflation and producer wholesale inflation were reported this week to have risen dramatically last month, according to the U.S. Bureau of Labor Statistics. Most do not argue over the fundamental economic, nor the mathematic, causes for the sharp growth in inflation. The great market debate, propelling increased levels of volatility, lies in the forecasts for future inflation – particularly, how high it will go and how long it will continue and persist.

The Federal Reserve remains on high alert, but nevertheless is continuing to stand down when it comes to combatting inflation. Although there is growing discussion over this stance within the Fed, the official line continues to be that increases in inflation are not only expected, but are in fact welcomed, as a strong signal of a healing economy. The Fed’s official view remains that current and future inflation will prove to be temporary as the supply side of the economy adjusts from pandemic constraints and manages to successfully catch up to pent-up demand at acceptably lower price points. And, if inflation in the coming quarters does not play out as the Fed forecasts, its officials remain confident in their ability to proactively extinguish any flare-ups if the economy shows signs of overheating.

The only certainty is that this inflation debate will not be going away anytime soon. The Fed has understandably remained vague on their 2% “average” inflation target to allow maximum policy flexibility, especially when it comes to allowing latitude to combat stubborn unemployment. U.S. money supply measures are at historically high levels, fueled by record fiscal recovery spending with a yet to-be-determined amount of additional spending on the horizon. Short-term funding rates continue to be held down at an absolute level of virtually zero. The Fed’s quantitative easing program of Treasury and mortgage-backed securities purchases remains at a constant $140 billion a month. Both these monetary actions may be contributing to a bubble in the residential real estate market.

Digesting and backing away from all this fiscal and monetary support will be precarious. The markets clearly have considerable concerns and doubts. The best advice in preparing for and managing volatility risk is to be proactive and advantageously hedge against expensive market movements.

Leap 1: Consumer retail inflation

The Consumer Price Index (“CPI”) rose 0.8% in April from March, expanding by 4.2% year-over-year (“YoY”) from April 2020 to April 2021, the largest rolling annual increase in the CPI since the last great economic debacle in 2008:

The core CPI, which strips out the volatile food and energy prices (especially as of late, read below), rose 0.9% in April, its largest monthly increase in nearly 40 years, contributing to a healthy 3.0% annual YoY increase. Both these retail inflation measurements exceeded expectations that were already forecasted to rise considerably.

Much of the rise in the annual measurements of inflation is due to the so-called “base effect” of measuring change from an extremely low level, as broad-based input and finished goods and services prices fell considerably in April 2020 from the pandemically motivated shutdowns and accompanying global economic collapse.

But beyond mathematical effects, there are real retail price increases throughout the economy. New and used vehicle prices continue to climb due to input shortages, including semiconductor chips, and bottlenecks in ramping up production. Used car prices spiked by 10% in April, the largest monthly increase in the history of recording secondary vehicle market prices. Rental cars are in short supply, and hence are at higher rates, as rental car companies liquidated a large percentage of their used car fleets per normal operating procedures, only to be unable to now replenish them. In fact, most semiconductor-dependent items, from consumer electronics to appliances, are all suffering from these same chip shortages.

There are other unique situations adding to constrained supplies and higher goods prices. The Ever Given (to be never forgotten), the cargo ship that got stuck in the Suez Canal in March, single-handedly created global shipping delays that still have a significant voyage back to normalizing. The more recent ransomware attack and subsequent shutdown of the Colonial Pipeline (reportedly resolved through a $5 million Bitcoin payment), which provides fuel to the Southern and Eastern parts of the country from Texas, has led to tight gasoline supplies and panic buying. The national average gas price at the pump has risen slightly in response, which will show up in May’s CPI report.

The overall climbing level of vaccinations, easing of restrictions, and stimulus check savings are beginning to unleash demand for services, as well as for goods. Dining prices are increasing. Vacation travel is burgeoning, leading to an increase in the prices of airfares, hotel rooms, and rental homes, on top of the aforementioned rental car price pressures.

Shelter-related costs, which make up more than a third of the CPI, are starting to move up after decelerating sharply during the height of the pandemic. A rebound in hotel room rates is the primary driver. However, rents in the largest urban centers have seen their bottom and are rapidly on the rise. The exodus from Manhattan is quickly reversing, especially among the younger adult community. Medical costs, although being flat for the month of April, are beginning to rebound as backlogs at doctor and dentist offices are clearing as the newly vaccinated rush to catch up on missed appointments.

Leap 2: Producer wholesale inflation

The Producer Price Index (“PPI”) rose 0.6% in April from March, as compared to forecasts that called for a median gain of 0.3%. The YoY rate of wholesale inflation in the rolling twelve months from April 2020 to April 2021 climbed to 6.2%, up from 4.2% last month. This is the highest YoY increase since the PPI was reformulated in 2009:

Back in 2009, a record spike in oil prices drove most of the increase in wholesale prices. Now, the cost of many raw and partly finished goods are rising, ranging from farm crops, to precious metals, to computer chips.

Rising wholesale prices are not always a sign of future inflation. Companies raise or lower prices for several reasons, and they do not always pass higher wholesale costs onto customers. However, current wholesale price increases are in fact getting passed on to the retail level. Wholesale prices began to rise sharply last year in a sign that inflation more broadly was about to surge. Now, much of those costs are being passed to consumers, as discussed above.

Raw material wholesale prices have climbed by almost 58% over the past twelve months. Wholesale food prices rose sharply in April by 2.1%. Rising prices of corn and other farm goods are expected to raise the cost of groceries in the coming months. The cost of energy fell in April for the first time since last fall, but energy prices are on the rise and will be adding to wholesale inflation.

The core PPI, like the core CPI which strips out the volatile food and energy prices, rose in April by 0.7%. The YoY increase in the core PPI moved up to 4.6% in April from 3.1% in March.

No leap: Retail sales surprisingly disappoint after the spike in March

Retail sales stalled in April following a sharp advance in March when pandemic relief checks provided millions of Americans with increased spending power.  The value of overall retail purchases was essentially unchanged last month following an upwardly revised 10.7% gain in March:

Stimulus checks apparently were mostly used up in March as the spending data shows, but households now hold larger savings than before the pandemic. This result reflects how the recovery is expected to be uneven, partly because spending will shift from goods to services. While consumers may begin to shift more of their spending on entertainment and travel as pandemic fears dissipate, elevated savings supported by additional fiscal stimulus should bolster retail demand in the coming months. Compared to a year ago in April 2020, the overall value of retail sales has increased by 51.2%.

The unexpected pause in retail sales helped to subdue the rise in interest rate swap levels and Treasury yields that peaked mid-week off the robust inflation reports. After climbing to just over 1.70%, the bellwether ten-year Treasury yield closed the week back closer to the 1.60% range:

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