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'Inflation is a process'

·Senior Markets Editor
·4 min read
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This article first appeared in the Morning Brief. Get the Morning Brief sent directly to your inbox every Monday to Friday by 6:30 a.m. ET. Subscribe

Thursday, March 11, 2021

Inflation might be coming. The data says: not yet.

In financial markets there are few things you can count on.

But one thing we know will surely come up sooner rather than later are widespread concerns about inflation.

The commodities cycle, the Treasury yield curve, growth forecasts, and easy comps all suggest that higher consumer prices are coming down the pike this year. Which made Wednesday's report from the BLS on consumer prices hotly anticipated by investors.

When the numbers dropped, however, they landed with a bit of a thud. At least if you were expecting to see inflation starting to take off.

In February, consumer prices rose 0.4% over the prior month and 1.7% over the prior year. On a "core" basis — which strips out the cost of food and gas and is more closely tracked by the Federal Reserve — prices rose just 0.1% and 1.3% over the last month and year, respectively.

None of this data screams inflationary pressure. Then again, inflation of the sort that gets Fed officials interested in changing their forecasts doesn't just crop up overnight. Nor will the data necessary to engender that kind of forecast re-evaluation materialize in the months ahead.

"The US inflation debate has become excessively binary: runaway inflation versus no inflation," said Gregory Daco, chief U.S. economist at Oxford Economics. "The most likely outcome is that after a spring peak, inflation will fall back while remaining above 2% for longer than at any other time over the past decade. By longer run historical standards, inflation is still set to remain relatively muted and a long way from spiraling out of control."

Last summer, the Fed outlined that it would now target average inflation of 2% rather than just 2% inflation. This may put to rest questions about whether 2% inflation was a ceiling or a floor for the central bank. The new framework also puts the Fed in a position to look past any near-term inflation pressures, potentially helping to avoid raising rates too quickly as they did in 2018.

In a recent note, we saw one strategist note that the stock market leads earnings, earnings lead the economy, and economic growth catches up last. The interplay between inflation and the bond market isn't so different — yields lead growth, growth leads inflation, and inflation catches up last.

And so we're really only on step one of a three-step process that might result in meaningful and sustained inflation pressures cropping up in the economy.

The Fed's new framework also allows the central bank to react to inflation in the way that inflation itself acts on the real economy. Which is to say: slowly.

"It is important to remember that inflation is a process, particularly outside of commodities," said Neil Dutta, head of economics at Renaissance Macro.

Dutta, like Daco, outlined in an email on Wednesday that in the coming months inflation will first spike because we lap last spring's depressed prices when the economic shutdown was at its most potent in the U.S. "This inflation surge is meaningless," Dutta writes, "the market is not surprised by year-over-year rates of change."

In the summer, additional re-opening alongside easing supply chain pressures will likely result in pockets of inflation but not broad overall price pressures. Another look-through from the Fed's perspective.

"The real inflation story begins when the labor market fully heals," Dutta adds. "The economy remains far from this point. Indeed, this year will likely bring with it a significant positive supply shock in the labor market as schools reopen."

And so we should expect plenty of fireworks on inflation data in the coming months, though none of this is likely to give the Fed any reason to change its forecasts. Even if — or perhaps especially if — the numbers might appear to suggest otherwise.

By Myles Udland, reporter and anchor for Yahoo Finance Live. Follow him at @MylesUdland

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