Too Complacent about Inflation

Over the past two months both the stock and bond markets have become far too complacent about the prospects for inflation. Indeed, after the Fed announced that it was talking about tapering, bond prices rallied sending the 10-year U.S. Treasury yield below 1.5%, well off from its 1.74% high. After the break in lumber, iron ore and copper prices the market has bought in hook-line and sinker to the Fed’s view that the recent uptick in inflation is transitory.

 

In my view the markets are way too complacent. Why? There are two long term and very sticky factors that will keep inflation well above 3% over the next few years. The first factor is that the reported owners’ equivalent rent component of the consumer price index increased at a very modest 2.1% from May 2020 to May 2021. However, in the real world according to CoreLogic single family home rents increased by 5.3% over the same time period. Thus, the official CPI has lots of catching up to do.

 

Second, although average hourly earnings for nonsupervisory workers increased at a modest 3.4% annual rate from December 2020 to May 2021, if you look under the hood wage gains are far from modest. For example, over the same time period the annual rate increase for manufacturing wages was 11.5%, leisure and hospitality 13.2%, construction 5.2%, professional services 6.4% and the much-maligned retail sector 4.8%. The low topline increase in wages is a result of mix change as lower wage workers reenter the workforce.

 

The market seems to be ignoring these data at its peril. Part of the reason, I believe, is institutional inertia; money managers are reluctant to make an out of consensus bet on inflation, because if they are wrong, it would become a career ending event. As a result, by this Fall much of the transitory factors may well have run their course, but the longer-term inflationary forces will come to the fore to the chagrin of most market participants.