Ida, petrol and inflation expectations

The Federal Reserve is catching some heat about inflation, but the Fed’s bet on it being transitory is correct, and price pressures will moderate later this year and in early 2022.

However, the Fed isn’t going to be off the hot sea soon. Hurricane Ida will put additional, temporary, upward pressure on growth in September’s consumer prices because of higher energy costs.

The Fed views fluctuations in inflation driven by energy prices as transitory and this won’t change unless there is a sustained increase in long-term inflation expectations.

Retail gasoline prices are going to increase. Wholesale gasoline futures, which lead retail gasoline prices by two

weeks, point to prices at the pump reaching $3.40 per gallon, compared with $3.24 in the week ended August 30, roughly a 5% gain. This is a fairly modest increase relative to that seen after Hurricanes Katrina and Rita in 2015, when retail gasoline prices jumped 20%.

It’s still unclear what the ultimate increase in retail gasoline prices will be because there are a number of refineries offline in Louisiana, and if they remain dormant for an extended period of time, gasoline prices will rise even further.

Odds are that energy prices will boost the headline consumer price index in both August and September.

Higher gasoline prices could ding growth but maybe not as much as in the past. We ran four different scenarios involving 5%, 10%, 15% and 20% increases in retail gasoline prices this quarter. We assumed gasoline prices remained above the baseline in the fourth quarter before falling back to the baseline in early 2022.

A 5% increase in gasoline prices would reduce real GDP growth by a little less than 0.1 percentage point over the course of a year. A 10% increase cuts GDP growth by 0.1 percentage point, and a 15% gain shaves 0.2 percentage point. A 20% increase reduces GDP growth by 0.3 percentage point. However, the hit to GDP growth could be less because of the significant amount of excess savings households are sitting on.

Higher energy prices could nudge inflation expectations higher. Our past work has shown that the five-year, five-year forward break-even inflation rate, which uses Treasury Inflation-Protected Securities, is sensitive to fluctuations in energy prices.

The Fed will look through any rise in market-based inflation expectations that is attributed to Hurricane Ida. However, the central bank will become increasingly sensitive to market-based measures of inflation expectations if inflation doesn’t moderate as soon as policymakers anticipate, and the labor market continues to improve.

We are closely tracking various measures of inflation expectations and one to keep an eye on is the five-year, fiveyear zero-coupon inflation swap rate. This differs from expectations based on TIPS.

A zero-coupon inflation swap is a derivative used to transfer inflation risk from one party to another through an exchange of cash flows. In a zero-coupon inflation swap, only one payment is done at maturity where a party pays a fixed rate on a notional principal amount, while the other party pays a floating rate linked to an inflation index.

On the other hand, TIPS pay a semi-annual coupon based on the principal value, which is adjusted for changes in the consumer price index. TIPS don’t protect against increases in real interest rates because, like nominal bonds, TIPS are exposed to movements in real interest rates while inflation swaps are constructed to prevent investors from being exposed to changes in real interest rates.

With data on the 10- and five-year zero-coupon inflation swap, we’re able to calculate the five-year, five-year swap inflation rate. This is another measure of inflation expectations, and it suggests that long-term inflation expectations are anchored just south of 2.4%. This is in line with that seen through 2018 but higher than that in 2019.

Inflation was moderating in 2019. Therefore, we could see the five-year, five-year swap inflation rate decline later this year and into next, providing the Fed some cover. Unless inflation expectations steadily climb, the Fed can be patient and not raise the target range for the fed funds rate for a while.

Is a bottom forming?

The gap between the U.S. 10-year Treasury yield and our estimate of its “economic fair value” continues to widen, but this could imply a bottom could form soon.

We use an ordinary least squares regression to estimate an economic fair value of the 10-year Treasury yield. A significant deviation from this estimate would imply that there are other forces driving long-term interest rates.

The five variables used in the regression are our estimate of monthly real U.S. GDP, the CPI, the current effective fed funds rate, the Fed’s balance sheet as a share of nominal GDP, and a Fed bias measure constructed using fed funds futures.

All five variables were statistically significant with the correct sign and explained 63% of the fluctuation in the 10year Treasury yield. The regression used monthly data. The model’s implied economic fair value of the 10-year Treasury yield in February—the latest available data for some of the explanatory variables—is 1.58%. This is only 28 basis points higher than the current yield on the 10-year Treasury.

Also, seasonals favor an increase in the 10-year Treasury yield in September. On average, over the past several years, Treasury returns have declined in September. Further, the 10-year Treasury yield has risen in four of the last five Septembers. We don’t anticipate a jump in interest rates this fall, but with seasonals turning less favorable, odds are rates will rise rather than continuing to drop.

This assumption could be wrong if the number of COVID19 cases continues to climb, increasing the economic costs.