It was a very volatile week of trading after the embedded CPI report. With the market skyrocketing but struggling to digest inflation data, only to give back all of those gains on Wednesday. Then the University of Michigan added Friday Another unexpected wrinkle when its survey of inflation expectations over the next 5 to 10 years jumped to 3.2%, well above the expected 2.9%.
What is clear is that wage growth, monthly changes in the consumer price index, and consumer inflation expectations are not in line with the federal inflation target of 2%. This will make the market vision of a rate cut later this year difficult to achieve.
High risk of not sticking to inflation
While many investors tend to dismiss consumer inflation expectations because of their relationship to things like gasoline or takeout, the recent uptick in consumer inflation should not It happened because we generally saw lower gasoline prices. That could either indicate that the University of Michigan’s preliminary number released on Friday is too high and will be revised downward, or that there is something else consumers are thinking about the direction of inflation.
It’s not just the University of Michigan poll recently that has seen inflation expectations rise. The Federal Reserve Bank of New York announced a rise in its three-year inflation expectations in April. Whether or not this trend continues in May and June will be very important, especially if the University of Michigan review continues.
If the University of Michigan number holds steady, it will be the highest final reading for that metric in years, and 3.2% has only been exceeded in the past on a handful of occasions over the past 30 years. In some ways, it appears to be a identification between firm and unfettered inflation expectations.
These consumer-based forecasts may be a better guide to where inflation is headed than market-based inflation expectations. Because when looking at the data, the consumer appears to have seen the bottom and top of the inflation range ahead of market-based expectations.
When you compare the New York Fed’s upcoming 3-year inflation forecast with the three-year break-even inflation forecast, along with the University of Michigan’s 5-10-year inflation forecast, with the five-year break-even point, it’s very easy to see how the consumer can- Forecasts based on the lows and exceeds months before the measures based on the market.
While this may not indicate that inflation rates are on their way to new highs, it could indicate that inflation will remain flat and very high and may swing in a range. It also indicates that market-based inflation expectations will rise again as the market realizes that inflation will be an issue for some time to come.
It brings the battle of inflation to a dangerous point because we may be at a point where inflation expectations are going up just because inflation has been so high for so long that the expectation is that inflation will remain high. If there is a shift in this psychology, it means that the market will soon rebound in that direction, driving up market-based measures of inflation.
Unconstrained inflation expectations lead to higher volatility
If market-based inflation expectations shift higher, it will remove interest rate cut expectations from the market as yields rise, thus creating more volatility in the market as it tries to figure out what comes next in terms of monetary policy.
Unfortunately, most investors associate volatility with a rise in the VIX or a decline in the stock market. But realized volatility works both ways when the market goes up and down. In fact, after hitting a low in mid-April, volatility has been on the rise, primarily due to the wide volatility that the market has experienced as it tries to digest all this economic and earnings data that seems to indicate compounding trends, as well as potential impacts from recent bank failures.
One would expect that if realized volatility continues to rise as market volatility increases, implied volatility will also follow in due course, especially as we move towards data points that have the potential to influence how the Fed leans towards the June FOMC meeting.
Test this week
One such event will happen on Friday, when FOMC Chairman Jay Powell and former FOMC Chairman Ben Bernanke will discuss monetary policy at a Federal Reserve conference call on Friday, May 19 at 11 am.
This will be the market’s first opportunity to hear Powell’s thoughts on current inflation and jobs data and to see if the University of Michigan data catches his eye as it did at the June 2022 FOMC meeting.
All of this, taken together, is likely to lead to more market volatility again this week and in the coming weeks as we find out whether inflation expectations have really changed and whether the data coming in suggests that the Fed may need to raise interest rates further.
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