Three Signs That Inflation is Cooling Off

The good news is that inflation is rising even though the Federal Reserve raises interest rates and stocks plummet.

According to data from the St. Louis Fed, inflation is expected at 2.86% per year over the next 10 years. This is according to the 10-year Treasury note break even rate. This might seem low considering that the consumer price index rose at an annual pace of 8.5% in march.

Inflation has been predicted to slow down for a long time. It is expected that demand will fall as consumers use the extra cash they have saved during the pandemic crisis. supply chain constraints slowly moderate. It is not clear how quickly annual inflation will fall.

The most recent data is positive. First, inflation expectations measured using the 10-year breakeven rate seem to have reached a peak of 2.9% in April. This was a 19 year high, and it marked the third time in the history of the pandemic when the rate climbed into the mid- to late nineties.

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This is because there was not much economic data that could have led to expectations of an annual inflation rate higher than 2.9% over the next ten years. This is also logical. The Federal Reserve is determined to reduce inflation and has made it abundantly clear that it will raise short-term interest rates several more times in the future to help curb economic demand.

Inflation expectations are important as employees and employers will expect higher wages. Companies will also charge more if they anticipate rapid price increases. The Fed is able to do its job more easily if there are lower expectations.

They are also important because they affect how fast or slow the Fed raises rates. For economic growth, the S&P500 and the stock market as a whole, slower rate increases are better.

Second, actual inflation has likely peaked, not expected inflation. The economy saw a rapid rise in prices compared to 2020, with CPI gains exceeding 5% by the middle of 2018. The year-over year increases in prices are expected to slow down since they were higher than a year ago.

Historical data shows that when the CPI gains reach their highest point for a given economic cycle it is often accompanied by 10-year inflation expectations peaking. CPI reached its highest levels in 2000, 2005 and 2008, as well as 2011, 2012, 2011 and 2018. Citigroup data shows that inflation expectations for the next ten years declined four of five times in the 12 months following.

The same story is told by oil price peaks. The price of West Texas Intermediate crude oil fell to $110 per barrel this year from $130 at the beginning of March, a multiyear peak. The price of oil reached multi year highs in 2008, 2013, and 2018. In 2018, three times as many 10-year inflation expectations were lower than the actual.

The stock market should rise if inflation expectations have reached their maximum. This means that the Fed will likely be less aggressive in raising interest rates than is currently anticipated. The Fed already stated this week that they are unlikely to raise interest rates by an increment of 75 basis points or 100ths of one percentage point. This leaves 25 to 50 basis point increases as the most likely move.

Stocks are still under pressure as the market still attempts to gauge the economic and earnings effects of higher rates. The S&P 500 is now at a level where buyers can step in. This week, the index has held steady at 4,070. It closed Friday at 4123.34