Inflation Will Offer Pleasant Surprise to Equity Markets

Get ready for good inflation.

Photographer: Michael Nagle/Bloomberg

To some, the U.S. economy is on the verge of experiencing a sharp upturn in inflation that will force the Federal Reserve to accelerate the pace of interest-rate increases. The reality is that the balance of risks around inflation has normalized, which should be good news for equity markets that have been on high on alert for the prospect of an aggressive Fed.

Inflation is usually viewed on a trailing 12-month basis, which means that if prices move sharply in a particular month, the shock is carried over for the next 11 months before it drops out. This is relevant because energy prices were declining around this time last year, causing a drag on the inflation data. But now, a simple model that translates the current price of Brent crude oil to an estimate for the headline personal consumption expenditure index suggests that measure of inflation will rise to 2.5 percent by July before retreating. That’s higher than the Fed’s current projections.

Some 60 percent of the run-up in oil prices from the lows can be attributed to low supply rather than high demand. After all, proxies for global demand such as copper prices and bond yields have not moved as much as oil. This is not surprising given escalating tensions in the Middle East. However, it does raise the risk that supply conditions could come into better balance once the tensions subside, sending oil prices lower. As such, the Fed should thus ignore the recent price run-up.

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