Market Is Still in the Denial Stage About Inflation

The latest US inflation report should be a reality check for Wall Street, but many investors are still wearing rose-colored glasses. Bond yields ticked slightly higher Wednesday after the Labor Department reported that consumer prices rose more than forecast last month, but they are still nowhere near reflecting the monetary policy path it may take to rein in inflation.

It’s easy to focus on the superficially positive parts of the report, yet the outlook is far more complex. The 8.3% increase in the consumer price index in April marked a slight slowdown from March, bolstering the view that the worst inflation in 40 years has peaked and is beginning its descent. But the figures confirmed that inflation is spreading from goods to service-related prices and indicate a long journey back to what the Federal Reserve may regard as stable prices.

Wall Street has picked up the bad habit of looking for reasons to explain away inflation — for months it was “just used cars,” and this month one could conveniently blame the 33.3% surge in airline fares for juicing the index — but price increases are now broad-based. Consider the Cleveland Fed’s median CPI and 16% trimmed-mean CPI measures, which aim to identify the underlying trend. Both are still rising year over year.

Even focusing on headline inflation, the Fed won’t take any satisfaction in knowing that the peak is behind it. Prices don’t rise at breakneck speeds forever, and there’s a certain gravitational pull that seems to kick in at uber-elevated price levels. But it’s easy to get stuck with bad-but-not-awful inflation. Consider that in the past century, the US has spent about 9% of its combined economic history with year-over-year inflation above 8%. Even in the infamously inflationary 1970s, it was only above 8% about a third of the time.

On the other hand, the US has spent considerably more time in the 3% to 6% inflation range, and there’s a real risk that the US economy will get stuck there again if the Fed doesn’t act decisively.

In the four decades since former Fed Chair Paul Volcker famously fought and vanquished the corrosive inflation that took root in the 1970s, US authorities made tremendous strides to anchor inflation at around 2%, which became the Fed’s explicit target in 2012 under the chair at the time, Ben Bernanke. The longer it stays above that target, the more the Fed risks seeing the gains of the past 40 years unravel permanently. That won’t mean 8% inflation, but it could mean 4% to 5% inflation that hurts the quality of life of many Americans.