In terms of expectations there was not much of a surprise in the inflation number. The Reuters poll of economists had already projected 7.9% consumer inflation in the US for Feb-22 and that is exactly where the actual inflation came in. For Feb-22, the pressure came from energy prices and from core inflation (excluding food and fuel). At 7.9%, the US economy is almost back to the early days of the Volcker era nearly 40 years ago when inflation was persistently at very high levels.
In fact, the consumer inflation at 7.9% in Feb-22 is higher than 7.5% in Jan-22. Also, the sequential spike in inflation was at 0.8% in Feb-22 compared to just 0.6% in Jan-22. In short, since the inflation started spiking in the US around May 2021, rate of inflation has traversed from sub-2% to 7.9%. This is substantially higher than the Fed inflation tolerance level of 2%.
CHART 1 - US Consumer Inflation over last 5 years (Monthly inflation YOY)
The sharp spike in US inflation makes a strong case for the US Fed to hike the rates in a calibrated manner. But, we will come back to that point later.
What triggered the spike in US inflation
Consumer inflation at 7.9% in the US when bond yields are under 2% is an extremely anomalous situation. It is resulting in deeply negative real inflation. Here were the drivers.
a) Rising energy costs has been one of the main reasons for this spike in consumer inflation. The war has already spiked crude by 88% in the last 3 months and sanctions on Russia could only deepen this problem.
b) Russia accounts for about 8% of global oil supply and it exports nearly 53% of its oil export basket to Europe and over 80% of its gas export basket also to Europe. Hence, the situation could get a lot worse if the EU also joins in the sanctions.
c) In the US, the month of Feb-22 alone saw gasoline prices surge by 6.6% and that contributed majorly to the high consumer inflation. On a 12 month basis, US gasoline prices are up 38% in tandem with rising crude prices.
d) The concern is that the inflation could get worse if the recent spike in oil prices are also factored in. Also, crude has strong externalities since it tends to play a role in the cost structure of most of the products manufactured or services rendered.
e) If you look at the groceries basket in the US, it is up 1.4% on a sequential basis and about 8.6% on a yoy basis. With the Black Sea blockade already on, the food equations are likely to be impacted. Analysts are already pegging Mar-22 inflation at well above 8%.
f) According to the Labour department, it was not just about energy and groceries. There has been as harp spike in a host of basket items including restaurants, food, transport, apparel and housing. The price hikes are across the board.
g) In the last few Fed policies, the FOMC has dropped the use of the word “transitory” to describe inflation. One of the key reasons for this high inflation has been that, across the board, supply of goods and services have failed to keep pace with the sharp rebound in demand. This led to shortages and supply chain bottlenecks, across the board.
h) One interesting aspect is that, even in the US, core inflation is a major problem. For instance, even if we were to exclude the volatile items like energy and food, the consumer inflation still rose 6.4% yoy, which can be interpreted as the core inflation. On a sequential basis, this core inflation is up 40 basis points from 6% to 6.4%.
i) Among other key items, there has been a slowdown in growth of housing rentals at 4.7% while prices of used cars has actually fallen. However, this comes after months of secular increase, so much of the damage is already in the price.
What does 7.9% inflation mean for Fed stance?
Fed is already prepared for higher inflation this year. The question is how the rate hikes will be calibrated in the light of the global chaos created by the Russia-Ukraine war and the recent spike in oil prices. While the war is likely to result in lesser number of rate hikes, the high inflation number certainly means that rate hikes are inevitable and cannot be really put off any further. It could start with a 25 bps rate hike in Mar-22 at the bare minimum.
In his testimony to the Senate Banking Committee, Jerome Powell had already warned about a spike in oil prices and sharper supply chain constraints. Considering that Russia is the largest contributor to the global oil pool, any restrictions will hit the equation hard. It is also very unlikely that either the US or the OPEC can fill up the Russian shortfall, if full-fledged sanctions were to happen.
Based on the recent Powell testimony, it looks like the first rate hike of 25 bps would come in Mar-22. However, the total number of rate hikes would most likely fall from 7 hikes to about 5 hikes. Also, amidst this state of macroeconomic flux, the Fed may choose not to talk about unwinding the bond portfolio for now. That is evidenced by the CME Fedwatch.
What does this US inflation number mean for India?
The US inflation was along expected lines, so there was no element of surprise. But if crude and energy are the main drivers, then India would also see sharply higher inflation in the coming months. Secondly, RBI may have to take up the first rate hike as early as Apr-22 policy, because the dovish stance and status quo is not in sync with rising inflation.
The positive takeaway is that the war may dissuade the Fed from winding down its balance sheet. That would, at least not put pressure on liquidity in the markets and the intensity of passive flows into India. For Indian corporates, the mandate would be to get more conscious on costs. That is still the best defence mechanism in tough times.