Inflation is back on the Wall Street radar this week, with the Consumer Price Index (CPI) and the Producer Price Index (PPI) scheduled for release on Wednesday and Thursday.
The consensus market forecast is a 5.3 percent annual rise for CPI and a 7.4 percent rise for PPI, according to Tradingeconomics.com.
Will CPI Increase?
CPI is a measure of how the cost of living changes over time. It’s the average change over time in the prices paid by urban consumers for a fixed market basket of consumer goods and services. Because it measures the changes in consumer goods and services prices only, CPI is a narrow gauge of
inflation. It’s also a measure of inflation at the retail level, which means the prices paid at local stores.
In June, the CPI rose 0.9 percent on a seasonally adjusted basis, rising 5.4 percent over the last 12 months, not seasonally adjusted. The index for all items less food and energy (core CPI) increased 0.9 percent in June, up 4.5 percent over the year.
Will PPI Increase?
PPI is a measure of how the cost of producing goods changes over time. It’s the average change over time in the selling prices received by domestic producers for their output. The prices included in the PPI are from the first commercial transaction for many products and some services.
When the PPI has a news release, its headline index is the Final Demand Index. The Final Demand Index measures the change in prices received by domestic producers for goods, services, and construction sold for personal consumption, capital investment, government, and export.
The PPI increased 1.0 percent in June, as prices for final demand services rose 0.8 percent and the index for final demand goods rose 1.2 percent. As a result, the Final Demand Index advanced 7.3 percent for the 12 months ended in June.
These inflation numbers are well above the Fed’s conventional target of 2%, but the nation’s central bank doesn’t seem to be worried, thus far.
Why the Fed Isn’t Worried about Inflation
Inflation is an old villain of market economies. It can be a little problem or a big problem, depending on whether it’s transitory or persistent.
Transitory inflation is temporary inflation due to failures of the supply side of the economy to accommodate a spike in demand for goods and services.
Persistent inflation, by contrast, is inflation due to the build-up of expectations among market participants who expect the imbalance between the demand and the supply side of the market to continue for a long time.
What’s the case right now? First, the Fed thinks inflation is transitory. As the Fed sees it, rising prices reflect delays in how the economy’s supply side is adjusting to the economic recovery from the COVID-19 pandemic. They are caused by “bottlenecks,” such as container shortage and port congestions, which prevent the supply side from responding fast enough to a rapid recovery of the demand side.
Simply put, bottlenecks create shortages, pushing prices higher. Bottleneck inflation is usually temporary, as price hikes will gradually taper off as supply catches up with demand. That’s why the Fed doesn’t worry about the recent spike in inflation and isn’t eager to change its accommodative policy.
Lastly, there’s one more reason the Fed isn’t in a rush to change its policy to deal with inflation: the fear that the early removal of this policy will push the U.S. economy to a Japanese-style deflation that is much harder to deal with than inflation.
Should Wall Street Worry?
Deflation is a far worse problem than inflation for Wall Street. The last time the American economy slid to deflation was back in the 1930s, a terrible time for Wall Street.
Then there’s Japan’s recent experience with deflation, which has caused a three-decade-long bear market. That’s why Wall Street should be on the Fed’s side this time around, and also should not worry about inflation.
There is an additional reason for Wall Street not worrying about inflation at this point: the 10-year Treasury bond yield, a measure of inflationary expectations, is currently at 1.29 percent. That’s well below the 2% it was a couple of months ago, when inflation numbers began to exceed the Fed’s 2 percent target.
Summary and Conclusions
Wall Street should be prepared for a couple of ugly inflation numbers this week. Supply-side disruptions are expected to continue creating shortages in the U.S. economy as it tries to recover from the COVID-19 recession. Of course, these shortages could ease once the economy returns to normal and supply catches up with demand.
Meanwhile, traders and investors should watch closely how the 10-year Treasury yield behaves, following the release of the July CPI and PPI numbers. That will help them figure out whether markets continue to
think that the spike in inflation is transitory, or is actually persistent.
