Outlook: Today the calendar includes import and export prices, the Empire manufacturing index, and industrial output. Canada reports Aug CPI.  Oil may be a focus as gas prices soared in Europe and US inventories today are expected to show a drop. Italy went so far as to cap prices.

The market is torn between being worried about the slowdown in China and rising inflation in the West, although the UK’s 3% is not exactly a barn-burner. Canada reports CPI today, expected higher at 3.9%, which would be the highest since March 2003. Core is forecast to be up by a lot less so that the BoC can stick to its transitory inflation narrative.

The main line of thought is that the inflationary effects of the pandemic are waning any minute now (i.e., the Fed is right about most price rises being transitory) but we say inflation is not so easily shoved off and besides, who says the pandemic is behind us? Note that commodity prices failed to get that message and are higher again today.

The consensus from the market on the CPI report: everything is hunky-dory, and the Fed is still on a long, long timeline before hiking rates. Granted, US inflation was a tad less than expected, especially in the core, leading some to believe the Fed was vindicated and inflation is only transitory. Therefore, the tapering announcement can go ahead at the November FOMC (with a nice hint in September) but actual rate hikes still put off until late in 2022 and into 2023.

We were surprised by the reaction to the inflation report—Treasuries and dollar way down. Perhaps we were over-influenced by the NY Fed’s inflation expectations report on Monday. It shows expectations for key categories up a lot more than what we have today (5.3% y/y in Aug). In fact, it’s more like 7-9%.

As for the “inflation mentality,” consider housing. CPI does not measure housing costs properly. Its measure for “owner’s equivalent rent” rose 2.6% y/y in Aug, at wild odds with Case-Shiller (19%) and the NAR report (23%). That’s because the BLS asks people what they think their house might go for if they were to rent it out whereas the other measures are based on actual sales. Housing is about one-third of total CPI, so hold that down, hold the whole thing down. But real people know their houses have risen and a lot over the past year—they can easily check it out on Zillow and other sites. This is the only kind of inflation homeowners like, but it’s still inflation not being measured and reported by the government, which can’t be good for trust among the public. 

A small minority see housing this way, too. Bloomberg reports fund manager Jeffrey Gundlach says that if the inflation stats “used actual home prices rather than owners' equivalent rent, CPI would be up 12% year on year.” Gundlach takes “issue with the notion that the current spike will be temporary and said Treasury Inflation-Protected Securities look ‘pretty expensive’ around current levels.”

Equally important, we have to question the Fed’s narrative that it’s only a small number of goods and services that are driving CPI, and a lot of those are pandemic-related. But housing, food, gasoline and medical care are not a small number of goods. They are practically the whole megillah. As for being pandemic-related, okay, but we have at least one instance of falling prices due to the pandemic—air fares. Besides, who says the pandemic will be over in 6 months or a year?

Financial professionals accept that the Fed is willing to let inflation run a little hot in order to take the average closer to 2%, the 2% target having been undershot for a long time and starting to look pretty silly. This makes sense only if you omit consideration of how humans make decisions. People do not consider that prices rose only 1% last year so 3% this year is okay because the average is 2%. Instead they freak out when contemplating that over the next year, the cost of renting a house/apartment is going to rise 10%, gasoline by 9.2%, food by 7.9%, and healthcare by 9.7%--especially when they think their salary/wage rise will be only 2.5% and not up to snuff. This is what the NY Fed survey found on Monday and it certainly points to an “inflation mentality” that is already stalking the land. Equally to the point, it’s a whole lot more than “running a little hot.” It’s on fire.

It's also a forecast and not a reality. But consider the second problem, the set of supply issues driving at least some of this inflation. The Atlanta Fed business inflation expectations is pretty tame, with unit costs expected up to 3.3% on average, but that’s the August report. Unit costs are terribly messy because unit labor costs are what we tend to focus on and for material supplies, we are kind of stuck with producer input prices. This is not realistic or representative because obviously not every producer uses every input, but the August PPI was up 8.3% (and we don’t get an update until Oct 14).

So, quick, pick a series of inflation numbers going forward that would meet the Fed’s criteria of “hot but  not on fire.” How about an average of 3.5-4.5% but not more for the remaining four months of the year in order to start tapering in January. Is that realistic? 

From whence comes a respite in commodity prices, let alone the central Thing, microchips? One answer is the end of the inventory rebuilding cycle. We searched high and low and can’t find any experts on that subject. Take cars. Yesterday’s data showed a drop in those famous used car prices but a rise in new car prices. This implies an inventory build in used cars. How long does it take for dealers to acknowledge they can’t get away with higher prices? Presumably the availability of no-longer-new cars next year will have something to do with it, but with the chip shortage and output cuts, new cars are only more expensive and folks will hang on to them longer, depriving the used car guys. You can get hopelessly tangled in these projections.

Bottom line: we say the Fed chickens out as data and expectations developments point increasing to the inflationary mindset getting a grip. Inflation will likely exceed the 3.5-4.5% not-on-fire range.

The CME Fed funds tool does not show those players buying into the inflation story just yet—it takes until the Dec 2022 meeting for expectations of a rate change to hit-- but just wait. The probability is not zero of that expectation creeping forward. To when? Well, let’s say March-April. March saw the first inflation over 2% (2.6%) and April is when it started going bananas (4.2%). By next March/April, we will have had inflation overshooting the 2% target by a lot and for a full year. Somebody will be sure to notice. We like the WSJ reporter’s comment: “By the time it is done with tapering, the risk is that the Fed might no longer be debating whether it should start lifting rates, but how much it should raise them.”

If and when this idea gets a grip, the dollar comes back. We are likely to be haunted by this demon until all the data is in. This is, of course, a minority view and also too far out into the future to be useful for making trading/hedging decisions today. But keep it in mind. What’s the probability of a re-think by the Fed based on inflation too high for too long? Somewhere between 30 and 50%. But the scenario can get derailed IF the commodity prices retreat, the supply situation eases and the inventory rebuilding goes fast. Notice we are not naming the demand side of the inflation story. That means we assume employment does pick up and wage hikes keep coming, so that consumers fulfill their manifest destiny, shopping.

For the moment we have lower yields and a weak dollar that represent something akin to faith in the Fed and its stance on inflation. The Fed economists are among the best in the world. (We’d love to get a sneak-peek at their calculations.) Perhaps the thing we should be forecasting is when the Fed acknowledges that inflation is not so easily tamed and we need to expect higher numbers for longer. This implies an earlier taper so the Fed can get on with rate hikes. In the end, we don’t buy the consensus story today and it’s nerve-wracking.

This is an excerpt from “The Rockefeller Morning Briefing,” which is far larger (about 10 pages). The Briefing has been published every day for over 25 years and represents experienced analysis and insight. The report offers deep background and is not intended to guide FX trading. Rockefeller produces other reports (in spot and futures) for trading purposes.

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This morning FX briefing is an information service, not a trading system. All trade recommendations are included in the afternoon report.

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