Inflation Will Push The Fed To Act

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Includes: AGG, DIA, IWM, QQQ, SPY
by: Roman Chuyan, CFA

Summary

The Fed's policies helped keep bond, stock, and other asset prices elevated in the face of negative fundamentals.

While still below the Fed's target, inflation started to rise recently.

If PCE inflation continues to rise, it will force the Fed’s hand in raising interest rates.

The Fed helped keep bond prices (NYSEARCA:AGG), stocks (NYSEARCA:SPY) and other asset prices elevated, in the face of negative fundamentals including economic and valuation. How will the tug-of-war between fundamentals and the Fed be resolved? One possible scenario: inflation reaches the Fed's target and forces it to tighten monetary policy.

The Fed has been trying to boost inflation since it dropped following the financial crisis in 2008-09. It finally turned up this year. In fact, core (excluding food and energy) consumer price index, CPI, inflation is at 2.2% (see chart).

CPI Inflation Rates, 20 Years

Total inflation rate, having rebounded from its 2015 low of around zero, is still low at 0.85%. It is important to understand the dynamic between total and core inflation rates. By design, total inflation includes both core inflation and the more volatile food and energy prices. If commodity prices didn't change, total inflation would be very close to the core inflation rate. As commodities fluctuate, total inflation fluctuates around the more-stable core inflation (see chart above), but always reverts back to core.

Since last year, total inflation rebounded despite the continued plunge in crude oil (see chart below) and other commodities. Commodities stabilized this year - for example, WTI crude oil price rebounded to $46 per barrel. While the future path of commodity prices is uncertain, if they remain stable it's only a matter of time before total inflation (currently at 0.85%) catches up to core (2.2%). CPI statistics will be released next on May 17, and are worth keeping an eye on.

Inflation Rate vs. Crude Oil Price, 10 Years

Rather than CPI, as preferred inflation gauge, the Fed follows another measure of inflation, the change in the core personal consumption expenditures (PCE) price index. This measure is now at 1.6%, still below CPI inflation.

To summarize, while the Fed's preferred inflation measure, at 1.6%, is still below its 2% target, core CPI inflation recently rose to 2.2%. Commodity rebound will push total inflation up to that level, likely in only a few months. If PCE inflation follows these other measures, it will force the Fed's hand in raising interest rates in order to moderate inflation, as its mandate dictates.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.