Scenario 2: What Could Go Right
If oil prices drop to about $80 per barrel, and supply chains heal in the near term, inflation expectations will remain anchored. This scenario allows the Fed to engineer a soft economic landing, avoiding a recession. Specifically, the Fed would be able to raise interest rates to the point that demand matches supply, and the economy continues to grow as inflation easily moderates.
Scenario 3: What’s More Likely
Based on today’s data, we believe what’s more likely to occur is something between these two extremes, where the year-over-year inflation readings start to trend lower in the next couple of months.
1. Inflation related to core goods declined in March by 0.4%. Core goods exclude food and energy products, and this decrease suggests a deceleration in this segment. Examples of core goods are new and used cars, clothing, sporting goods, and electronics.
2. The average mortgage rate jumped from 3.3% to 5.1% since the beginning of the year, making it more expensive to service debt. In addition, housing prices have risen about 19% over the past year.
It will be difficult, if not impossible, for housing prices to sustain this growth because interest payments are much more expensive now. For example, your principal and interest payment on a 30-year fixed rate $300,000 loan would be $315 more per month compared to the beginning of the year.
3. Through the first half of the month, the average price of oil has been about $100 per barrel. Oil would need to have an average price of about $116 for the rest of the month to match March’s average oil price. So, as long as oil is relatively stable, energy prices should be a negative contributor to April’s inflation.
Barring the “what could go wrong” scenario, the three factors cited above should result in upcoming monthly inflation changes that are lower than last year: April 2021 +0.6%, May 2021 +0.7%, and June 2021 0.9%.
Year-over-year inflation would still be high, no question, but it would also be lower. As a result of the still-high inflation, the Fed would probably hike short-term interest rates at every meeting this year, including a half-point hike on May 4. Additionally, the Fed would begin to shrink its $9 trillion balance sheet by roughly $95 billion per month to help ease inflationary pressures.
Earlier in this column, I discussed the need for inflation expectations to remain anchored so that it doesn’t spiral out of control. Fortunately, expectations are anchored.
We observe this in a few ways. One is to look at the difference in yields on TIPS (Treasury Inflation-Protected Securities) compared to normal Treasury bonds. This spread tells us the amount of inflation the bond market expects. Presently, the expected consumer inflation (CPI) over the next year is 5.7%, but that falls to 2.9% for the “Year 1” to “Year 2” period.