Our outlook still calls for U.S. inflation to moderate over the course of 2022, but the U.S. Consumer Price Index report for January ups the risk that the U.S. Federal Reserve may tighten too aggressively, says Brian Levitt.
Hopes that U.S. inflation pressures would begin to ease were not met today as the U.S. Consumer Price Index (CPI) rose by a higher-than-expected 0.6% in January. Headline CPI over the past year has climbed by 7.5%, the highest level since 1982. Core CPI, which excludes food and energy, has climbed by 6%. Core service prices jumped 0.44%, reflecting a larger-than-expected gain in medical services and rent inflation. Goods inflation remained firm, driven by higher costs for used vehicles and apparel. New car prices flattened out for the month.1
U.S. market reaction
Immediately after the report, market sentiment in the U.S. soured amid expectations of tighter monetary policy. As of this writing, however, equity markets seemed to be taking it more in stride.
- The market is now expecting six interest rate hikes this year, up from five prior to the CPI release.2
- The probability of a 50-basis point rate hike in March by the U.S. Federal Reserve Board increased from 28% before the release to nearly 50% this morning.3
- Interest rates have been rising across the U.S. Treasury yield curve, with the 10-year rate approaching 2% soon after the release. The 2-year U.S. Treasury has now climbed from 0.2% at the beginning of Q421 to nearly 1.50%, representing a meaningful tightening of the U.S. Treasury yield curve.4
The risk to the current business cycle is elevated. Cycles don’t end on their own volition, but rather the demise is almost always the result of tighter policy. We would expect financial conditions to tighten, albeit from easy levels, driven by higher real yields and widening credit spreads. Our outlook calls for U.S. inflation to moderate over the course of the year driven by base effects and slowing consumer demand — but we recognize that the risks to that call are elevated.
The U.S. economy is likely to slow meaningfully as the Fed tightens policy and as American consumers grapple with higher prices for food and rent. In the slowdown phase of the cycle, we still favour equities but expect volatility to persist amid policy uncertainty, returns to become more modest, and the range of outcomes within equity indices to become more extreme. Higher quality businesses with pricing power and greater visibility of earnings will likely outperform as financial conditions tighten, in our view.
Inflation and Fed tightening hasten the end of business cycles. We still believe our base-case scenario will come to fruition, in which inflationary pressures ease as consumer demand slows and supply-chain challenges recede as workers return to the factory floors. However, we recognize that the probability of a “persistent inflation” scenario, in which central banks tighten too aggressively and choke off economic growth, has risen.
1 Source of all inflation data: U.S. Bureau of Labor Statistics as of 1/31/22, released on 2/10/22
2 Source: Bloomberg, L.P., as of 2/10/22. As represented by the Fed Funds Futures Implied Rate. Fed funds futures are financial contracts that represent the market’s opinion of where the federal funds rate will be at a specified point in the future. The federal funds rate is the rate at which banks lend balances to each other overnight.
3 Source: Bloomberg, L.P., as of 2/10/22. As represented by the Fed Funds Futures Implied Rate.
4 Source: Bloomberg, L.P., as of 2/10/22