One of the officially stated reasons why the Fed delayed hiking rates so far, is because inflation in late 2015 and early 2016 has been lower than the Fed's bogey (as long as one does not look at core inflation, or such critical price levels as asking rents and health insurance). And, based at least on the CPI's basket weighing of headline input prices, the Fed may have been right: the main reason for this is that tumbling energy prices have resulted in a sharp drop in gasoline prices at the pump, one of the primary drivers of Headline CPI.
What is left unsaid is that keeping rates low has been a blessing in disguise for the Fed: following the early 2016 market rout, which was the functional tightening equivalent of three rate hikes, Yellen was happy that inflation was low enough to let her get away without a rate hike so far this year.
However, as we approach the anniversary of last year's oil - and gasoline - price lows and the base-effect goes away, the sharp pick up in gas prices is set to have an even sharper upward impact on Consumer Price Inflation. It will also wreak havoc on the Fed's strategy of playing possum and not hiking as long as inflation remained "stubbornly low" because suddenly inflation will be the highest it has been in years.
In short: the Fed suddenly has a problem. Here's why.
As BofA writes in a note today, the recovery in oil prices this year should lift headline CPI inflation, "confirming the transitory nature of the energy drag." What is startling, however, is that assuming BofA's gas price forecast is right, the bank calculates that its baseline forecast is for CPI to rise to 2.4% by year-end 2016 from the current 1.1% reading. This forecast uses futures prices for wholesale gasoline (RBOB) to estimate future energy prices.
Note that 2.4% CPI inflation in December is BofA's base case, based on an all too realistic gas price of $1.77/gallon retail ($1.41 wholesale). According to BofA's "bull case" in which gasoline returns to its historical price of $2.76/gallon ($2.06 wholesale) would more than triple headline inflation from its current 1.1% level to a whopping 3.5%: this would be a shock to the Fed, to inflation expectations, and to the market. It would also force the Fed to hike rates far faster than the market currently expects.
Here is the math:
Futures wholesale prices are set to inch up from $1.64/gallon to $1.65/gallon in June before ending the year at $1.41/gallon, above the December 2015 level of $1.27/gallon. We sensitize our inflation forecast by defining “bull” and “bear” cases for gasoline prices in addition to our baseline. In particular, we use the highest and lowest observed RBOB price over the last twelve months. This means a bull case of $2.06/gallon and bear case of $1.07/gallon wholesale, by year-end, with the shock gradually building over our forecast horizon. $1.41/gallon wholesale would be $2.11/gallon for retail gasoline, assuming a steady wholesale-retail spread of $0.70 (which covers distribution/marketing and taxes). Our “bull” case would be $2.76/gallon retail and the “bear” case would be $1.77/gallon retail.
The impact of the base-effect is so pronounced, that as BofA notes, an extreme bearish scenario is needed for inflation to stall. A far less extreme scenario is needed for inflation to jump dramatically. To wit:
Our analysis shows that there is a clear uptrend in CPI ahead, under most reasonable scenarios (Chart 1). CPI would accelerate to 3.5% yoy under our bull case, and rise to 1.6% under our bear case. Supportive base effects are a key driver. It is only under an extreme bear case (year-end wholesale gasoline price of $0.88/gallon, or retail at $1.58/gallon), that we would see CPI inflation flatten out at 1.1%, all else equal.
What about after 2016? BofA again:
One of the key reasons why we think CPI is set to head higher later this year is because of base effects: gasoline prices were so low late last year that it’s hard to get to a lower year-on-year comparison point come late-2016. This “base effect” will push the year-on-year rate higher in late 2016. Beyond that, we continue to see elevated inflation, but the trajectory slows slightly through 2017.
The one saving grace the Fed may have if challenged with suddenly surging headline CPI is that inflation expectations will lkely be far slower to rise.
In contrast, market-based inflation expectation measures such as the Fed’s 5-year breakeven inflation rate remains subdued, currently at 1.5%. A simple correlation chart shows that the Fed’s 5-year breakeven inflation rate closely tracks gasoline prices (Chart 2). Thus, inflation expectations may only rise if gasoline prices/energy costs push higher. But as a recent Fed paper argued, both TIPS breakevens and oil prices are driven by the same factor: changes in the outlook for global economic activity. Thus, a rebound in market-based inflation expectations may require a rebound in aggregate demand. Furthermore, breakevens face many headwinds, including investor doubts about central bank credibility. Add it all up, and we see a much more protracted recovery for inflation expectations than for actual inflation.
That said, even with depressed and delayed inflation expectations, Yellen will be hard pressed to explain why she isn't aggressively hiking at every opportunity if and when headline CPI rises to 2.4%, let along the "bull case" of 3.5%. We wonder how long until China figures this out. We also wonder if the recent near doubling in oil prices, so eagerly greeted by the Fed, will not be promptly undone by the very same Fed which will need to get gas price inflation out of the picture if Yellen wishes to preserve the optionality of keeping rates low any time the market suffers an even modest 5% selloff.
In short, keep a very close eye on gas prices: over the next few months, gas prices will become far more important to the Fed's monteray policy than even China.