Talking points: Sticky inflation

What an inflated week, with so much volatility in the capital markets! We asked our council of writers - Cristiano Robondo, Joe Bullden and Justin Bearber - to answer some of our questions on inflation and interest rate hike.

What caught your eye on the US inflation figures?

Robondo: US inflation for August came in red-hot. Compared to July, both the CPI and core CPI rose 0.1% and 0.6% respectively. Looking at a year-on-year basis, CPI and core CPI advanced 8.3% and 6.3% respectively.

Bullden: The street, including yours truly, expected inflation to be lower. This is due to falling oil prices. Instead, the August CPI was a shocker, beating market expectations of 8.1%.

Robondo: Falling oil prices had an impact on CPI. Gasoline prices fell 10.6% in August, the biggest monthly drop in more than two years. But it was not enough.

Bearber: Everything else increase. Food costs rose 11.4%, the most since 1979. Electricity prices jumped 15.8% from 2021, the most since 1981. Shelter costs, a third of the CPI index, rose 6.2% from a year ago. This is the most since the early 1990s.

More alarmingly, inflation (excluding transitory items) has reached new high. This means that inflation is sticky and will not vary much unless there is a recession.

Robondo: Agreed. Inflation is happening across all categories. One indicator of the broad-based inflation is Federal Reserve Bank of Cleveland's median CPI. This has jumped 6.7% from a year ago.

How will the US Fed react to the hot inflation data?

Robondo: Well, the Fed seems to be behind the curve when it comes to inflation. Fed Chair Powell has gotten much flak for calling inflation ‘transitory” last year. He was slow in hiking interest rates. Now, he is facing a tough choice as inflation is now running super-hot at 8% to 9% handles. This is far above its 2% inflation target.

Bullden: The market is expecting the Fed to hike 75bps in its coming September meeting. This will bring the upper bound Fed Funds rate to 3.25%.

Bearber: The surprise will be a 100 bps hike. This will be a Volcker-esque signal that the Fed is doing whatever it takes to fight inflation.

Bullden: That will be shocking! And will scare the markets.

Bearber: But there is a case for a big rate hike. The gap between inflation and Fed Funds rate is just too wide. A 100bps hike will only put the upper bound Fed Funds rate at 3.5%. This implies a gap of 4.8%, even higher than the Fed Funds rate. Furthermore, the inflation is broad-based and sticky. The situation is out of control. Doing too little may result in soaring inflation to continue unabetted. So, it may be better to bite the bullet and take the pain.

Robondo: But a hefty rate hike will slow the economy and result in a recession. This is something that is politically unacceptable for US President Joe Biden, especially with the approaching mid-term elections in US.

Bullden: Poor Joe-Biden.

What are we seeing in the bond market now?

Robondo: The bond markets are really struggling. Yields have skyrocketed with 2-year yield at 3.90%. I remember 2-year yield was at 0.2% last year. Now, it is 19 times higher. Tough!

Bullden: Well, the 10-year yield has also risen to 3.46%, about doubled a year ago. But this is not as high as the 2-year yield.

Bearber: Well, this is bad data point. The yield curve has inverted, with short-term yield higher than long-term yield. This means that the markets are expecting a recession.

Bullden: Ouch!

Bearber: And the Fed is also increasing its quantitative tightening. In September, the Fed is increasing its quantitative tightening cap from $45 billion to $95 billion. This will further drain liquidity from the financial system.

Robondo: Super Ouch! We are seeing the impact now. This is after a crazy two years of quantitative easing where the US Fed doubled its balance sheet to $9 trillion, equivalent to roughly 40% of US GDP.

Any last words for next week?

Robondo: The US Fed is having its September meeting on 20th and 21st. It will offer an insight into how the Fed plan to tackle this inflation problem.

Bullden: Hopefully, just a 75 bps rate hike.

Bearber: Let’s have the 100 bps hike and get inflation under control.

The article is contributed by EdNeverSlumber. You can read more of his investment insights on his substack.