The CPI report has become one of the most anticipated macroeconomic data points. However, this month’s data has even more significance after Jay Powell’s testimony, which signaled that the Fed could consider raising interest rates by 50 bps at the March FOMC meeting.
For February, analysts forecast overall CPI to rise 0.4%, lower than January’s 0.5%, while core CPI is expected to rise 0.4%, the same as January. Headline CPI is expected to rise 6% year-on-year in February, down from January’s 6.4%, and core CPI is expected to rise 5.5% year-on-year compared to February’s 5.6% .
The swaps market and the Cleveland Fed both indicate that the CPI report may show higher inflation than analysts are predicting. The February CPI swap is trading at 6.043%, while the Cleveland Fed projects an increase in CPI of 6.21% y/y. Both are higher than analysts’ estimates and have been reasonably accurate in predicting actual CPI YoY inflation.
Recently, the Cleveland Fed has tended to overstate CPI YoY inflation, while CPI inflation swaps have understated the CPI reading. For example, the August CPI report was below the Cleveland Fed and inflation swap estimates, while it was warmer than expected in September and October. However, the CPI report was cooler in November and December than expected. The actual reported value was warmer than CPI swap rates in January and February, but below the Cleveland Fed’s estimate for both months.
The CPI swap data point suggests we could see a reading above the 6% value currently predicted by analysts, resulting in a warmer than expected CPI report.
If the swaps market is correct and the CPI report comes in higher than analysts’ estimates, it will again signal that inflation remains stickier than analysts have generally assumed for some time.
Over the past few weeks, the swaps market has consistently raised its inflation outlook. The most significant changes have been for the second half of 2023, with swaps now pricing inflation rates 40 to 80 bps higher than they were after the mid-February CPI report.
The bond market has also confirmed the expectation of higher inflation, with 1-year break-even inflation expectations rising sharply in recent weeks, rising from 2.6% on 10 February to 3.2% on 10 March. These are the highest inflation expectations seen since mid-August. indicating a significant shift in the market’s outlook on the inflation outlook over the past month.
One possible reason why inflation expectations may be rising is that core benefits from former shelters have been consistently around 6% since September, falling only 50bps from a peak of 6.7% to 6.2% in the past few months. This decrease is much smaller than the overall number, indicating that specific sectors may experience more sustained inflationary pressures.
Furthermore, there are indications that commodity prices may have risen in February, as used car prices rose by over 4%. Historically, used car prices correlate positively with month-to-month commodity price changes. Commodity prices had been falling recently, but this changed in January when they rose for the first time since August.
Furthermore, copper prices have risen recently, thanks to a re-opening of China from its Covid-zero policy, which has also affected the ISM index of producer prices paid. This increase in copper prices may be a leading indicator of higher commodity prices in the future.
Therefore, core services from a shelter remain sticky and commodity prices begin to rise again. The combination could put upward pressure on inflation again and create a problem for the Fed, especially at a time when energy prices have been subdued.
All of these developments have made the market increasingly nervous, as seen in the higher level of implied volatility for the S&P 500. There has been a sharp increase in implied volatility from March 13 to March 14, with IV rising from 18% on Monday until 14 March. 26.3% Tuesday.
Should the CPI report continue to indicate that inflation is elevated and sticky, the market will be forced to continue to reassess its view of inflation and how quickly it will fall. This will require the swap market and breakevens to adjust accordingly, meaning interest rates will have to rise further.