US Near-Term Inflation Expectations Jump, Strengthening Case for Another Fed Rate Hike

What happened

The Federal Reserve Bank of New York's (NY Fed) Survey of Consumer Expectations reported that one-year-ahead inflation expectations rose to 3.9% in September, a 0.3 percentage point increase from August and the highest level since May 2023. Three-year expectations also edged up to 3.3%, while five-year expectations held steady at 3.0%.

The rise in near-term inflation expectations was broad-based, with notable increases in expected price growth for gasoline (4.8%), food (5.5%), medical care (9.2%), rent (6.8%), and college costs (7.5%). Interestingly, labor market expectations improved, with the perceived probability of losing one's job falling to 13.5% (the lowest since December 2024) and job finding expectations rising. However, expected earnings growth fell to 2.6%, while expected spending growth rose to 5.5%, the highest since May 2023. Consumers also reported a worse financial situation than a year ago and expect further deterioration, with perceived credit access worsening.

These data were released hours before the minutes of the Fed's September meeting, which indicated that most members of the monetary policy committee considered another interest rate hike likely by year-end, following the unanimous quarter-point increase to the 3.75-4% range.

Why it matters

The jump in near-term inflation expectations is a critical factor for the Federal Reserve, as it signals that inflationary pressures may be becoming entrenched in consumer psychology. The Fed's concern is that elevated inflation expectations for a prolonged period could influence wage and price decisions, making inflation more persistent. The stability of five-year expectations, however, offers some reassurance, suggesting that the long-term anchor still holds.

The fact that consumers expect prices to rise faster than their wages, while simultaneously planning to increase their spending, points to potential continued demand-side pressure, complicating the Fed's task of controlling inflation. The improvement in labor market expectations, while positive, could be viewed by the Fed as a sign of a still-tight market, which also contributes to inflationary pressures.

Market impact

• Interest Rates and Bonds: Short-term Treasury yields tend to rise, particularly at the front end of the curve, reflecting the increased likelihood of another Fed rate hike. The stability of five-year inflation expectations may limit the impact on longer-dated bonds for now.
• Dollar and Exchange Rates: The US dollar tends to strengthen against other currencies. The prospect of higher interest rates in the US makes dollar-denominated assets more attractive to yield-seeking investors.
• Equities: Stock markets may react negatively. Higher interest rates increase borrowing costs for companies and can reduce the attractiveness of equity investments compared to fixed-income securities. The survey also indicated that consumers are less bullish on equities.
• Commodities: The increase in expected gasoline prices suggests that energy costs are influencing consumer inflation perceptions. This could make oil supply disruptions a more direct risk to the Fed's outlook, potentially boosting oil prices.
• Brazil: A stronger dollar and the prospect of higher US interest rates can exert depreciating pressure on the Brazilian real. Furthermore, rising Treasury yields tend to reduce risk appetite for emerging markets, including Brazil, which could lead to capital outflows and negatively impact the Ibovespa.

What to watch

Upcoming inflation data (Consumer Price Index - CPI and Producer Price Index - PPI), employment reports (payroll), and, crucially, statements and decisions from the Federal Reserve at upcoming meetings will be key. The October 27-28 policy meeting will be central to observing whether the stability of five-year expectations holds, especially with energy prices remaining high.

Scenarios

Base Case: The Fed implements one more rate hike by year-end, with short-term inflation expectations remaining elevated but long-term expectations anchored. This would maintain pressure on short-term yields and the dollar. Risk Scenario: Long-term inflation expectations begin to rise, signaling a de-anchoring. This would force the Fed to adopt an even more aggressive stance, with more severe implications for global fixed income and equity markets.

Original source: ForexLive (InvestingLive). For information only, not investment advice.