Inflation Inertia

Fixed Income Households are barely holding on.


Inflation rose to over 5% in June 2021; but, the Fed, along with many investors and economists, look the other way. They took the view that it would pass; and pointed to outliners that used car prices and gasoline prices were up 45% year over year (y/y) in June. But, people still need to drive, and new cars are hard to find due to supply chain disruptions; so, these outliers hurt.

Inflation remained above 5% in July, August, and September. Then in October, Inflation jumped to a 6.2% y/y, the highest it had been in 31 years.

What about 2022?

Inflation seems to be holding steady. Since the beginning of 2021, month over month (m/m), inflation has averaged 0.6%, or three times the average during 2017–2019, according to the Consumer Price Index (CPI). All indicators point to y/y inflation being expected to remain above 6% until, at least, February 2022; and is not expected to drop below 5% until May.


So…, inflation will have averaged 5.4% for over a year, June 2021–May 2022. The CPI reading went above the 0.2% trend line beginning in January 2017, as noted in the chart below. The economy has already made up for the price drops of 2020’s pandemic lockdown, and with the passing of every month, it’s rising farther above the historical trendline.


The Fed’s 2020 monetary policy aimed to get inflation running above the 2% target for a limited time in order to stimulate the economy; but, no one expected the run-away inflation of today. Suppose that m/m inflation remains at 0.6% for another six months (0.6% is also the average for the past ten months). In that case, y/y inflation would rise above 7% this month and peak at nearly 8% in February–March 2022, and it would only drop below 5% somewhere around November 2022. With this scheme, inflation would average 5.4% over two full years, from 2021 through 2022.

What’s driving inflation and what to expect

Several forces are pushing monthly inflation higher.

  • The labor market remains tight; it has been tight, even after supplemental unemployment benefits expired in September.

  • The National Association for Business Economics (NABE) survey shows labor shortages will remain well into 2022. It’s become somewhat of a Bidding War: Employers are scaling wages higher while more workers are quitting to secure higher pay.

  • The continuing rise in rents and house prices fuel ongoing Housing Inflation.

  • Supply difficulties are expected to push costs higher well into 2022.

Let’s examine the importance of inflation expectations.

For the past several months, elevated inflation has begun to impact both inflation expectations and price-setting. Recent surveys, including one by the University of Michigan and the U.S. Conference Board, shows that consumers are increasingly concerned inflation will keep eroding their purchasing power as we advance.

  • Meanwhile, firms notice that strong demand gives them more pricing power, which helps them offset rising costs and improve their margins. It seems we are transitioning from price stability and cost compression to rising input costs and output prices.

In October, the Fed Chair, Jerome Powell, admitted that the Fed’s patient approach might not be suitable for an environment of sustained supply bottlenecks and energy price increases. For the first time, Powell was more concerned about inflation than unemployment.

  • Bond markets inflation expectations have started catching up with consumers and businesses. The five-year break-even inflation rate, a measure of market expectations for CPI inflation over the next five years, rose to its highest level, above 3%. Market expectations of rate hikes have also become more aggressive.

The Fed announced it would begin slowing its asset purchases, although its balance sheet will keep growing through the middle of 2022 because the Federal Open Market Committee (FOMC) does not seem to be raising interest rates anytime soon. And, FOMC will probably become more dovish when the three vacancies it now has been filled in 2022.

It’s also pertinent to note that 10-year U.S. Treasury yields are at just over 1.6%, which are not appealing when headline inflation is running at 6%. This may be telling us that the Fed’s strong presence in fixed income markets may be manipulating prices.


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