Inflation Stays Broad And Elevated As The US Economy Roars Back

Inflation stayed broad and elevated in January, according to a U.S. government report on Thursday.

The U.S. Bureau of Labor Statistics (BLS) reported that annual inflation rose to 7.5% in January, up from 7% in the previous month. That was the highest inflation number since 1982 and ahead of market forecasts. Core inflation, which excludes food and energy, came in at 6%, up from 5.5% in the previous month, meaning that inflation is expanding beyond food and fuel.

The hot inflation numbers came a few days after the U.S. government reported that the nation’s economy is roaring back from the COVID-19 recession. Last Friday, the BLS reported that U.S. businesses added 467,000 jobs in January, well above the 150,000 markets had expected. Unemployment increased to 4% while the December jobs report was revised upward to 510,000.

Economists are almost unanimous that a strong economy puts pressure on wages and prices. If going unchecked, it can set the economy into a vicious wage-price spiral, which could bring back an old villain of the American economy, stagflation.

Wall Street didn’t know what to do with the numbers. On the one side, the debt market sold off across the board, with the 10-year U.S. Treasury bond exceeding the psychological level of 2%. Higher inflation is a negative development for fixed-income securities, as investors demand higher returns to compensate for the decline in the real value of their investments.

On the other side, U.S. equities declined sharply across the board at the opening, but they recovered by 10:30 a.m., only to sell off again.

Apparently, equity traders are confused about how a strong economy and rising inflation can affect the performance of equity markets. On the one side, the strong economy is a boon to the top line of economically sensitive companies listed on major exchanges, as it leads to higher spending.

“Rising inflation hasn’t stopped consumers from spending as we continue to see strong purchasing trends, especially year over year,” said Jonathan Silver, founder & CEO at Affinity Solutions. “This is a good sign for a rebounding economy in 2022. We’ve also seen retailers try to keep pace with shoppers by not only looking to hire more help, but also to retain their current employees.”

On the other side, the rising inflation could push the Federal Reserve to take liquidity out of the economy with several interest-rate hikes.

“Today’s CPI bolsters arguments for the Federal Reserve to begin raising interest rates in the months ahead,” said Calvin Schnure, senior economist at Nareit.

That’s a negative development for equities, especially for companies that trade on the promise of future earnings rather than current earnings. Interest rates are the discounting factor in most valuation models, and rising interest rates push the valuations of these companies lower. Thus, the bigger sell-off in the Nasdaq, where the majority of such companies trade.

Still, some market observers believe that the spike in inflation is temporary. Silver is one of them.

“Despite another uptick in inflation, we’re optimistic that we will start to see prices come down a bit over the next few months. In addition, the Fed will likely accelerate its plans to raise rates while the supply chain bottleneck should get resolved, which will certainly help ease pricing,” he said.

The easing of inflation could signal the end of the Fed’s tightening cycle, and therefore, be a good development for equities. Providing, of course, that the Fed hikes do not push the economy into another recession, as has been the case in the past.