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Does hot inflation stop? 3 signs that show it is.

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Expectations of inflation are crucial to how quickly the Fed raises interest rates.

Frederick J. Brown / AFP via Getty Images

The good news about inflation breaks out even as the Federal Reserve raises interest rates and stocks fall.

Right now, the market is showing that inflation is expected to average 2.86% a year for the next 10 years, according to the St. Louis Fed’s so-called break-even rate for 10-year Treasury notes. This may seem low given that the consumer price index has risen by 1 annual rate 8.5% in March.

But inflation has long been expected to slow. The logic is that demand will decline consumers spend extra cash during the pandemic crisis, at the time restrictions in the supply chain are gradually being tolerated. The question is how quickly annual inflation will decline.

The latest data look favorable. First, inflation expectations, as measured by a 10-year break-even point, appear to have peaked at 2.98% in late April. It was a maximum of 19 years and became the third time during the pandemic, when the figure rose to the mid-nineties before declining sharply.

This reflects the fact that recent economic data did not have much to create expectations that annual inflation averaged more than 2.98% over the next 10 years. It also makes sense. After all, the Federal Reserve is firmly committed to lower inflation and has made it clear that it will raise short-term interest rates many more times to curb economic demand.

Inflation expectations are important because if the population expects prices to rise rapidly, employees will demand higher wages and companies will charge more, forcing workers to ask for more money. Lower expectations facilitate the work of the Fed.

They are also important because they affect how quickly – or slowly – the Fed raises rates. A slower pace is better for economic growth
S&P 500,
and the stock market as a whole.

The second signal is that actual rather than expected inflation has probably also peaked. Prices in the economy grew rapidly in 2021 compared to 2020, with mid-year CPI growth of more than 5%. Since prices were high a year ago, growth over last year is likely to be moderate.

Historically, when CPI growth reaches its maximum for a given economic cycle, it often means a peak in inflation expectations over 10 years. In 2000, 2005, 2008, 2011 and 2018, the CPI reached its peaks. According to Citigroup, ten-year inflation expectations fell four times out of five over the next 12 months.

Peaks in oil prices tell the same thing. This year, the price of West Texas Intermediate crude fell to $ 110 a barrel from a long-term high of $ 130, which was reached in early March. In 2008, 2011, 2013 and 2018, oil prices reached multi-year peaks, and 10-year inflation expectations fell over the next 12 months in three of these four cases.

If inflation expectations have indeed been exceeded, it should boost the stock market. This means that the Fed will raise interest rates less aggressively than currently expected. This week, the Fed has already said it is unlikely to raise interest rates by 75 basis points, or hundredths of a percentage point, leaving an increase of 25 to 50 basis points as the move moves.

Stocks are still under pressure because the market is still trying to assess the full extent of the impact on the economy and profits from future high rates. But the S&P 500 finds a place where buyers enter. This week, the index has repeatedly stabilized at around 4070. It ended on Friday at 4123.34.

Write to Jacob Sonenshein at jacob.sonenshine@barrons.com

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