Inflation, Hikes and Cooling Growth

Yesterday we had the US CPI releases for December, which broadly matched market expectations, at 7.0%yoy, and 5.5%yoy for the Core reading. CPI was driven to its 39-year high by increases in housing and used vehicles prices as well as the unavoidable high food costs, meanwhile, energy prices fell in December. Interestingly, inflation-adjusted average hourly earnings fell 2.4%yoy; clearly the surge in prices is eroding average higher wages.

If we look a bit closer at the inflation figures, the Sun Belt States appear to be the worst hit by rising costs, with many not far off double-figure inflation rates. In a survey of 14 metropolitan areas undertaken by the Bureau of Labour Statistics, Atlanta saw prices rise 9.8%yoy in December (driven by transportations and apparel), and Phoenix experienced a 9.7%yoy rise. Meanwhile, San Francisco and New York saw YoY price increases of 4.2% and 4.4%, respectively.

The inflation report will reinforce the Fed’s dot plot which suggests a rate hike this quarter. The futures market’s expectation for lift-off at the March FOMC meeting now stands at 90% (from 86% pre-inflation print). The Fed’s Bullard is calling for four hikes this year, adding that it's important to begin “sooner rather than later”. Many Fed members have also highlighted the need to start reducing the central bank’s USD8.8tn balance sheet. Of note, having doubled in size since early 2020, the balance sheet is still expected to remain sizeably larger than it was in 2008. On Tuesday, Fed Chair Powell said it could take as many as four more meetings until a firm plan for balance sheet reduction can be formulated.

Over to the Fed’s Beige Book, where the spike in inflation was underpinned by “solid growth in prices charged to customers”. Other key highlights included: “modest” growth in the final weeks of December, but business expectations cooled in certain areas following a surge in Omicron cases. “Optimism remained high but waned somewhat, as the share of firms expressing positive expectations for continued economic growth over the next six months narrowed,” the report said. Many districts reported supply chain disruptions, thus constraints to growth, and concerns over the pullback in the leisure and hospitality industry were noted.

The threat of elevated inflation globally is sending many central bankers and policymakers into reaction mode, as many find themselves “behind the curve”; we believe this creates an environment for policy error. The Fed, for example, could overtighten at a time when the economy is not strong enough to cope with higher interest rates. Throw into the equation a sharp withdrawal of liquidity (globally) amid slowing growth and higher interest rates, and we have heightened recession risk.

Fixed Income Team