It is not only the Fed that has had to recalibrate its view on inflation in recent weeks. Investors and traders are not certain how high and how persistently high inflation will be in the coming months, while they have poured much more investments into commodity-tracking exchange-traded funds (ETFs) as indirect tools to hedge against runaway inflation.
The Federal Reserve publicly dropped at the end of November “transitory” as the closest description of surging consumer prices, after insisting for months that inflationary pressures—also due to rallying energy prices—were only transitory and would soon subside.
But the slide in oil prices at the end of November, when benchmarks crashed by more than 10 percent in a single day for the worst daily performance this year, has led in recent weeks to money managers reducing expectations of inflation in the long term.
The heightened volatility in oil prices over the past month is complicating both the market and Fed’s outlook on inflation in the near term.
“Transitory” Inflation No More
At the end of November, U.S. Federal Reserve Chair Jerome Powell said that “transitory” should be dropped as an attribute to inflation.
“It is probably a good time to retire that word,” Powell said during testimony to the Senate Banking Committee.
Analysts interpreted these comments as the Fed possibly moving faster with the planned tapering of asset purchases and potential interest rate hikes as early as next year.
In the latest Federal Open Market Committee (FOMC) Statement, the Fed said on Wednesday that inflation had “exceeded 2 percent for some time” and signaled the possibility of three hikes in the federal funds rate next year.
U.S. Annual Inflation Jumps The Most Since 1982
In recent months, U.S. inflation has been running much higher than the Fed’s 2-percent target, also due to the rallying energy prices this year as oil and gas demand recovered from the pandemic as the economy reopened. Apart from directly hurting U.S. drivers with the highest gasoline prices in seven years, high prices of crude oil and natural gas make manufacturing and shipping of goods more expensive, indirectly hitting consumers with higher prices of everything they buy.
U.S. consumer prices jumped by 6.8 percent for year ending November 2021, which was the biggest 12-month increase in nearly 40 years, since the period ending June 1982, the Bureau of Labor Statistics said last week. Energy prices surged by 33.3 percent over the last year, and food prices increased by 6.1 percent.
When gauging inflation, the Fed generally excludes energy, but the high energy prices have already made the manufacturing and transport of goods other than fuels more expensive than at this time last year.
Investors Temper Inflation Expectations After Oil Price Slide
The highest annual inflation in the United States in 39 and a half years was not unexpected, considering the elevated energy prices and supply chain bottlenecks as economies reopened this year.
However, even with the recent decline in oil prices due to fears of the Omicron variant, some portfolio managers believe that inflation reflects broader additional global market forces than the mere price of energy.
“This is not a traditional commodity-driven cost shock. It’s much broader,” Rupert Harrison, portfolio manager at BlackRock, told The Wall Street Journal’s Joe Wallace.
The drop in international oil prices from this year’s highs at the end of October, when Brent Crude hit $85 a barrel, could help tame—to an extent—the surge in consumer prices, but some money managers expect that inflation could be long lasting.
“The oil price decline is helpful…but I wouldn’t overstate how important that is,” BlackRock’s Harrison told the Journal.
Nevertheless, investors have reduced their long-term inflation expectations, judging from the market of bonds. The ten-year breakeven inflation rate—a measure of expected inflation derived from 10-Year Treasury Constant Maturity Securities and 10-Year Treasury Inflation-Indexed Constant Maturity Securities—fell to 2.39 percent on December 15 from a high of 2.76 percent on November 15, according to data from the Federal Reserve Bank of St. Louis. The value implies what market participants expect inflation to be in the next 10 years, on average.
Commodity Funds As Inflation Hedge
Commodity-tracking funds and inflation-adjusted U.S. Treasuries have seen a surge in inflows this year as investors have moved to protect against rallying consumer prices.
Money flows into energy-related stock funds surged to a record high this year, according to data provider EPFR cited by the Financial Times.
For example, one Invesco ETF tracking commodities such as crude oil, copper, and soybeans, has seen more than double inflows between January and November compared to the same period last year, to $2.4 billion. But in the first half of December, money managers withdrew $400 million out of the fund, the FT notes.
Uncertainty about oil and other energy prices next year and the volatility of the oil market—torn between bearish Omicron and oversupply narratives and a bullish factor with Fed’s hawkish approach to fighting inflation—makes inflation forecasts more difficult to make.
By Tsvetana Paraskova for Oilprice.com
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