The current oil shock will undoubtedly cause an increase in prices on top of the existing affordability crisis.
While Federal Reserve Chair Jerome Powell recently said that longer-term inflation expectations remain well anchored, we think that investors should not repeat the same mistake that was made during the pandemic, when the Fed and others discounted shorter-term inflation expectations in favor of longer-term expectations.
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In previous inflation spikes, the criticism of the monetary authorities was that they paid too much attention to well-anchored long-term expectations of inflation at the expense of reacting to the rapid increase of short-term prices and the public’s expectations.
Today, after five weeks of attacks on Iran and the retaliatory attacks on Middle East energy production facilities, inflation expectations for the year ahead have spiked to 5%, according to daily estimates derived from the TIPS bond market.
That is a long way from the Federal Reserve’s 2% inflation objective.
Using the Federal Reserve Bank of New York’s survey of consumer expectations taken before the war, the median for year-ahead expectations was 3%.
That is still much higher than the February headline consumer price index rate of 2.4%, but in line with January’s personal consumption expenditures index rate of 2.8%.
The PCE for February will be updated on April 9 and the CPI for March will be updated on April 10.
Both of those measures are sure to increase along with the cost of energy, but they remain lagging indicators of the price instability that households and businesses are already facing.
The takeaway
As has been the case since the pandemic, inflation and inflation expectations have remained above the Federal Reserve’s 2% target. We do not expect that to change.
We do expect the monetary authorities to factor shorter-term expectations into their policy decisions, a process that is already difficult as the Fed tries to fulfill its dual mandate for price stability within an economy operating at full employment.
The short-term money markets are pricing little movement in the federal funds rate over the next 12 months.
With the energy shock continuing to unfold, we expect inflation in the near term to reach between 4% and 5% over the next three months.
Should the war be wrapped up in short order then we expect a move back toward 3%.
If not expect Fed rhetoric to shift toward paying closer attention to near-term metrics and public expectations of inflation so the errors made during the pandemic are not repeated in this episode.
