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Core CPI and Financial Markets

Federal Reserve Mandates


The Federal Reserve is tasked with implementing monetary policies to influence money and credit conditions in the economy. The primary objective of the FED is to fulfill its two mandates – full employment and stable prices.


Today, in the March 2021 FOMC meeting, FED Chairman Powell once again reiterate the FED's stance that any short-term rise in inflation will be temporary (transitory). Chairman Powell also reminds investors the FED does not anticipate raising rates even if the year-over-year Core CPI exceeds the 2% threshold.


Rising Inflation Beyond the 2% Threshold?


Although Chairman Powell may right above the rise in inflation is temporary, he may also be wrong over the near-to-medium term. Why? The March, April, and May 2020 monthly Core CPI readings (i.e., -0.3%, -0.7%, and -0.1%) were extremely negative numbers as they occurred during a once-in-a-hundred-year pandemic that resulted in an unprecedented global business shutdown.


The recent three month's Core CPI readings have begun to steadily rise from 0.2% (Dec 2020) to 0.3% (Jan 2021), and now to 0.4% (Feb 2021). As the March-May 2020 numbers roll off and the economy reopens, it is reasonable to expect the next 3-month's CPI core numbers (Mar, Apr, and May 2021) will rise, resulting in the year-over-year rate of inflation rising and possibly exceeding the FED's 2% threshold.


So, the question then becomes – if the rate of inflation begins to exceed the FED's 2% threshold and stays above this level, will this trigger widespread concerns of hyper-inflation? And most importantly, what will happen to the financial markets?


Previous Periods of Rising Inflation


In the past 20-years, the US economy has experienced two bouts of sharply rising inflation – from Nov 2014 to Sep 2016 and Oct 2010-Apr 2012. Both times, the Core CPI soared sharply higher. From 2014-2016, the Core CPI skyrocketed from 1.09% to 2.93%. From 2010-2012 the Core CPI exploded from a low of 0.60% to a high of 2.31%.


Two important points:


First, the two periods of rising inflation were not sustainable as the Core CPI eventually reverted down. Second, during the two distinct periods of soaring inflation, the financial markets reacted differently.


From November 2014 to September 2016 timeframe:


As the Core CPI exploded from a low of 1.09% to a high of 2.93%, the following occurred in the financial markets: US Dollar Index was mixed. It initially jumped sharply higher from a low of 80.85, reaching a high of 91.57 before plummeting sharply lower toward the end of the rising inflationary period. Commodities, as represented by the CRB Index, also exploded from the mid-260s to the mid-300s. US interest rates witnessed a spectacular jump as the 10-year US treasury yields (TNX) soared from 3.84% to 5.14%. The US stock market rallied strongly, as SPX rose from around 1,100 to a high of 1,340. From the perspective of the growth versus value call, S&P Growth Index (SGX) underperformed S&P Value Index (SVX). During the same period, the technology sector (XLK) also underperformed the SPX Index (SPX).


From October 2010-April 2012 time frame:


As the Core CPI skyrocketed from 0.60% to 2.31%, the following occurred in the financial markets. US Dollar Index (USD) quickly soared from a low of 72.93, reaching a high of 83.04 before leveling. The CRB Index plummeted from a high of 370.56 to a low of 272.97 during this timeframe. US interest rates (TNX) also declined sharply from a high of 3.45% to a low of 1.49%. The US stock market experienced a period of volatile sideways trading range fluctuating between 1,131.42 and 1,408.47. The growth versus value call favored S&P Growth Index (SGX) as this investment style outperformed S&P Value Index (SVX). Also, the technology sector (XLK) modestly outperformed the SPX Index (SPX) during this timeframe.


Conclusion


Rising inflation will likely occur as the three new monthly Core CPI for Mar, Apr May 2021 replace the negative readings from Mar, Apr, and May 2020. The year-over-year change may even lead to the Core CPI exceeding the FED's 2.0% threshold. Remember, financial markets such as TNX and SPX are leading indicators of business cycles. These markets tend to discount the economy many months and possibly quarters in advance of the actual occurrence.


We recommend investors and traders monitor the current rising inflation trend looking for clues as to whether we may be repeating either of the two previous periods of rising inflation since each offers two different financial market outcomes.


Source: Courtesy of StockCharts.com

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