U.S. Core Inflation Is Sticky, But…

U.S. core consumer price inflation remains slightly above the Fed’s stated target, but not worryingly so.

U.S. core CPI is running at 2.3% on an annual basis. Modest inflation is broad-based – core goods, core services (excluding shelter), and the shelter component are all in the 2% range. Notable sectors where inflation is rising faster than the overall rate are restaurants (3.1% yoy) and apparel (4.7% yoy).  The latter is likely to roll over later in the year now that the spike in cotton prices has subsided. The shelter component remains problematic because it is heavily weighted in the index and currently reflects an imbalance between the demand and the supply for rental units versus units for sale, rather than a reflection of broad inflationary pressures.

Nonetheless, the Fed has been very clear about the path for monetary policy, and we do not expect that inflation will rise outside of the Fed’s comfort zone in 2012.

U.S. Treasury Yields: Range-Bound For Now

The 10-year Treasury yield will remain in a range of 1.7% to 2.5% on a 12- to 18-month horizon. 

US Treasury Yields Range Bound

O ur framework for determining the fair value for yields is based on a review of the individual components: real yield, inflation expectations and term premium. The real yield is closely tied to the expected future path of real short-term rates. Because the Federal Reserve continues to demonstrate an easing bias, real yields will remain subdued, absent any major positive revisions to economic growth.

Chairman Bernanke’s comments this week reinforced that he is not swayed by the recent improvement in jobs data. He remains concerned about the sustainability of the recovery and the amount of slack in the labor market. As for inflation expectations, they are caught in a tug-of-war between a dovish Fed and measures of realized inflation that have begun to trend lower.

Typically, continued shifts toward easier Fed policy would boost long-term inflation expectations and also push the inflation risk premium higher. However, PCE inflation has been trending lower for three consecutive months. We continue to believe that the current environment is more deflationary than inflationary and that the level of expected inflation is too high relative to the real yield.

If negative real yields are truly justified, then inflation expectations should resume their downward trend over an intermediate time horizon.  The final component – the term premium – is where the bulk of the surprise may lie.