By Lisa Abramowicz
Feb. 14, 2022
The past week sent three important messages about the U.S. economy, markets and the Federal Reserve.
First, inflation is growing more embedded in the economy in a way that makes policy makers deeply uncomfortable. Second, more investors and consumers see the pace of price increases -- and potential Federal Reserve response -- as expediting an economic downturn. Third, although the collective wisdom of the markets suggests investors are sure where growth and inflation will end up, the path to getting there looks much more alarming.
So, despite the government saying Thursday that its consumer price index rose 7.5% in January from a year earlier, the biggest increase since 1982, there still seems to be a massive divide between those who believe inflation has become entrenched and those who believe that it will prove transitory, even if they don't want to use the "T" word.
Federal Reserve Bank of St. Louis President James Bullard appeared to side with the entrenched camp by saying he favored raising the central bank’s target for the federal funds rate — currently at 0.25% —100 basis points by July. Market expectations for a 50-basis-point rate increase at the Fed’s next policy meeting March 15-16 surged to a 90% chance at one point from a negligible one just a few weeks ago.
Even though bond yields shot up, the way yields rose seemed to support the transitory camp, if only because the economy is headed for a dramatic slowdown. More specifically, the gap between short- and long term yields, better known as the yield curve and a traditional indicator of coming economic distress, contracted dramatically. The difference between two- and 10-year Treasury note yields narrowed to less than 44 basis points, the least since August 2020. Also, longer-term inflation expectations fell, with the five-year, five-year forward breakeven rate dropping to 2.1% from as high as 2.4% in October.
Perhaps more importantly, the University of Michigan’s consumer sentiment index for February fell substantially more than forecast, dropping to the lowest since 2011. The survey showed that consumers expected inflation to average 5% over the next year, up from last month’s reading of 4.9% and the highest since 2008, but they left their view of longer-term inflation unchanged at a more moderate 3.1% rate.
The near-term outlook for price increases prompted 26% of consumers surveyed to say they expect their financial prospects to worsen, the highest share since 1980. After all, recent increases in compensation have failed to keep pace with inflation, meaning so-called real wages are declining. In fact, the consumer price index report showed that average real weekly wages fell by 3.1% in January from a year earlier, the most in data going back to 2007. This will make many Americans less willing to keep buying at the same pace given the greater cost of goods.
It’s also notable that Treasuries still served as a haven for investors on Friday when concern mounted that a Russian invasion of Ukraine might happen within days. Yields on 10-year Treasuries fell back below where they were ended Wednesday, the day before they shot up following the consumer price index report. Although investors seem worried about inflation getting away from the Fed, they're not worried enough to shun the creditworthiness of the world’s biggest economy in times of trouble.
Many influential investors and economists believe we're in a period of more entrenched inflation, but the market keeps seeing a much slower path of economic growth ahead. We are in unprecedented economic times, and nobody can know for sure what lies ahead, but the signal from the collective view of the markets is clear: we're heading to the same place we were before the pandemic. The path there, however, just got much rockier.
Lisa Abramowicz is a co-host of "Bloomberg Surveillance" on Bloomberg TV.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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