Inflation and the inflation markets

Hello, and welcome to Global Research Unlocked, the interest rate and FX series. This podcast is based on our weekly client conference call, where our strategists, along with guests from other parts of B of A Global Research, discuss the most topical and pressing questions faced by our market. I'm Mark Capelton, head of Global Inflation Link Research.

It's Friday, May 29th. I'm joined today by colleagues from the U.S. and European economics and rates strategy teams to talk about inflation and the rates markets, the inflation-linked rates markets in particular. The four of us put together our monthly Inflation Strategist publication, and the May edition came out this morning.

So, the ideas we'll discuss now are all freshly baked, hot from the oven. For any conflict disclosures related to any securities discussed in the call, please refer to the call invitation. So, let's start with U.S. economics.

We have Steven Juneau, who is responsible for our U.S. inflation forecast. Steven, early into the Iran conflict, it seemed that Europe was very vulnerable to the inflation shock we were experiencing, while the U.S. was relatively immune. Now, it's less clear what's been driving the recent jump in U.S. inflation.

Is it more than just Iran, and have we seen the full effects of the energy shock? Thanks, Mark. Great question.

It is mostly Iran so far, at least when you look at the headline index. Obviously, energy prices have surged in the U.S. Gas prices are running a little bit around $4.50 per gallon right now, so you've seen a big increase.

They were below $3 for context before Iran started. That's obviously translating into higher headline inflation. And then you're seeing some upticks as well, some spillover, a little bit, I think at least, in terms of things like airfares, delivery services, postage fees, and the like.

So, Iran is definitely a big factor in terms of the recent surge. And of course, besides that, we've had tariffs that are ongoing, too, right? So, we have seen tariffs reverse, but tariffs are still kind of translating.

That pass-through was still happening in, say, the first quarter of this year. We think that tariffs have added about 70 basis points to current core PC inflation, so when you take out tariffs, core PC is around 2.5%, 2.6% year-over-year. So those two factors are the big story.

Another new factor that we're realizing right now is that, well, AI PAPX, I think, is starting to spill over into the consumer. And it was already showing that kind of last year in electricity prices, but now it's showing itself in things like computer software and accessories, computers themselves, smartphones as well. So, you're starting to see that demand from businesses lead to higher prices for consumers.

It's not necessarily a consumer demand-driven inflation problem, but it is a demand-driven inflation from the business side, so that's another factor to consider. Then on your last question, have we seen the full effects of Iran? We don't think so yet, because we've probably seen most of the effect on energy to date, so that sequential increases for energy will probably start to decline over the next couple of months, or at least peak, say, next month or two.

But what we haven't seen yet, at least not fully, we think, is that pass-through to core. We have to remember that this energy shock to Iran is raising prices for inputs across the supply chain. It's raising prices for delivery fees, for transportation services.

That's eventually going to pass through, and we're now at, say, three months of this conflict ongoing, and that should lead businesses to try and push through the higher input costs to consumers gradually. So we expect inflation to be a little bit more sticky in the second half of this year than we did previously. So basically, we should see sticky high inflation throughout the entire year for the U.S. economy.

Thanks. And as you pointed out, we're not far removed from the inflation surge that we saw in 2022, and that was when CPI peaked at around 9% year-on-year. Do you see similarities to that period, and what are the differences?

Yeah, absolutely. We see a lot of similarities, and I would say it's more concentrated on the supply chain side. We had a similar energy shock then, right?

We saw supply chain pressures really build then, too, because, of course, you had issues, one from, obviously, COVID-related disruptions, but also from Russia-Ukraine war. So if you look at the New York Fed's global supply chain index, it's increased to nearly two standard deviations away from normal over the last three months. So that's causing some issues that look very similar to 2022.

When you look at earnings transcripts as well, you see a lot more mentions of higher material costs, similar to what you saw in 2022. So it does seem like the U.S. economy is experiencing, again, another negative supply shock, similar to what we saw in 2022 with Russia and Ukraine. But where it differs is what I would say so far is that the demand side factors aren't the same.

The labor market then was much tighter. You had two job openings for every unemployed person. You saw wages really accelerate into that.

People who were switching jobs were getting much higher premiums than those who were staying in jobs in terms of wage premiums. The other factor, of course, then versus now is that, well, fiscal policy was a much bigger force at that time in terms of driving demand-driven inflation. Consumers were flushed with COVID-related stimulus.

We have to remember that the U.S. Congress poured in, I think, around $6 trillion in COVID-related stimulus. About $2 trillion of that went directly to households.

So that helped support really strong demand, particularly for goods in the face of higher prices, and it contributed to that inflation surge that we saw then. Today, of course, fiscal policy is also stimulative, but the magnitude, the scale is much smaller. On the household side, we think the one big beautiful bill probably reduced household tax burden by about $140 billion, far below that $2 trillion number.

So you just don't have that same demand-side driven factors. You don't have the same labor market dynamics either that you did in 2022, but you do have a lot of similarities on the supply chain side. So I think that limits the upside that you can see on inflation.

It's not that inflation won't continue to move higher in the near term. It's just that in order for it to repeat what we saw in 2022, you'll have to see demand really pick up, too. It can't just be driven by the supply-side shock.

Okay, thanks. I guess the big question, what do you think all of this means for the path of Fed policy rates, especially with the arrival of the new governor? What will he think of this?

Yeah, well, he said that he would prefer to look through any and all supply shocks. So what I've kind of argued already is that the economy is experiencing, again, supply-driven inflation from a negative supply shock. It's not necessarily a demand-driven inflation situation.

So his goal would be for the Fed to look through this and kind of look at underlying inflation measures like, say, trim mean inflation, which actually held at, say, 2.3% when you look at the Dallas Fed measure and say, well, underlying inflation is a lot better. We can ease rates. This is going to fade.

Now, I think the committee has a much different view on this now because we've seen a series of repeated supply shocks. We've now seen inflation above the Fed's target for over five years. We're going on six years now.

And the committee is becoming increasingly worried that you can't just look through all these supply shocks when you've missed your target for so long because then it becomes almost an embedded problem. You can see inflation expectations move higher. You can see wage-setting behavior just incorporate the fact that inflation is running at 3% rather than closer to, say, 2%.

That feeds into stickier inflation over the medium term. So the committee, I think, is poised to basically stay on hold until they see a resolution, until they see some signs of labor market weakness or labor market strengthening, or until they see something change. But as long as inflation is running above 3%, the labor market is stable, I think the Fed is likely going to stay on hold.

Our call is that the Fed will basically be on hold until the second—or will be on hold until the second half of next year. And then by the second half of next year, they'll see inflation come down to, say, a mid-2% level, and they'll be able to cut rates by 50 basis points in the second half of next year to 3.125, which is their estimate of long-run rates. But I think the new Fed chair, Kevin Walsh, is going to have a hard time convincing the committee right now, unless he gets some type of weak economic data, particularly on the labor market side, that they should be gearing up to cut rates further in the second half of this year.

Thanks. Stephen and the team have put out a great primer, everything on Kevin Walsh, everything you want to know about his thinking on—what we know about his thinking on lots of areas, so please grab a copy of that if you can. Bringing in Megan Swiber from U.S.

Rate Strategy and our U.S. inflation market specialist, Megan, you've done a lot of analysis on positioning in lots of different ways. What is positioning like across markets right now? Sure, Mark.

So, we've had very significant swings in positioning over the past three months. So, just taking a step back here, the market was expecting that Walsh was going to come in as Fed chair and cut rates. We have the market long duration, we have the market in steepeners.

We had a lot of long positions in gold with the view that that was going to be the better asset class that was going to diversify and provide value versus Treasuries, folks for short dollar. Across all those asset classes, positioning really has reversed. This is, of course, largely driven by the surge in inflationary concerns that we're seeing stem from oil, but also supply chains, as Stephen stepped through.

A lot of strength that we see in the underlying data right now are our fantastic B of A, CAR data continues to show a lot of resilience of the U.S. consumer, which has been the engine of the U.S. economy for some time now. We're still seeing resilient labor data, and certainly next week will be an important check on this. Alongside all of this reconsideration around just how dovish Walsh can conceivably be here, the strength in the data, the strength of the inflation data, we've seen the market position very squarely short duration, and long every type of spread product you can think of.

So long Treasuries on an asset swap, long credit, long MBS, but also very long risk assets in general. And we see this in a lot of the great work that our cross-asset team has done on this, the flow show, the bull bear indicator all suggest that risk asset positioning is quite long right now and vulnerable. So I would say overall, Mark, the market's short duration, short rates, pretty neutral curve, but very long risk right now as well.

And how should investors think about trading the inflation curve? I think such an important question, right? So there's three things that I would highlight when we think about different points of the inflation curve.

So spot, which you can gauge as one year inflation swaps, tend to trade very closely with oil prices. You look at the beta that we've seen and have some nice charts in the inflation strategist in our note this week, just show that very, very tight relationship that we see between spot, one year inflation and changes in oil prices. If you move further off the curve, so let's think about belly forwards, like one year, one year, two year, three year inflation.

A lot of us who focus very much on the inflation market will tell you that trades like risk asset. And we see that that one year, one year point in particular demonstrates a lot of sensitivity to things like equities. So if you're looking to trade equity market risk sentiment, that belly portion of the curve or forwards is what, what translates a lot to that.

And I would say that five year, five year inflation to me is a decent read on fed reaction function and fed credibility. That suggests that inflation, long run inflation expectations have remained quite well anchored alongside the conflict in Iran. And what we actually saw immediately in the conflict was that that five year, five year inflation measure declined largely on this concern that this could drive that to be more aggressive or more hawkish than necessary.

We really haven't seen that show meaningful signs of on anchoring rather, we've just seen more so in recent weeks, the correction to long run rather than split. Very squarely how I would think about it spot, all about oil, forwards, particularly these belly forwards, all about equities and five year, five year, a decent read on the fed reaction function and credibility. Great.

Thanks. Given that and Steven's inflation views, what do you think is interesting in the US inflation market at the moment? We've got to consider positioning here alongside this too.

The way that we're framing this is that you can use inflation markets to position for some of this risk that we think is underpriced. So listening to Steven, so much of the increase that we've seen in spot inflation has been all about oil prices. Much get repriced in our view for what the knock on impacts of supply chains could look like and outcome where the conflict goes on for longer than expected.

So once we get some resolution, we're not really seeing oil pass through the straight as much as what the market's pricing and expecting. Talking to our commodities team, they still see a lot more of the tail risk, a lot more of that fatter tail and higher oil prices versus lower oil prices at this point. There are these risks to inflation that are around the corner at the markets under appreciating from an oil perspective, from a supply chain perspective, and then also this underlying risk that we see from a risk asset standpoint as well.

Thanks, Megan. Turning to Europe, Alessandro Inflasio on the Euro area economics and also on the UK. Alessandro, our commodity strategists have just revised their natural gas price forecast profile lower.

How has this affected the inflation outlook, do you think? Thank you, Mark. And hello, everyone.

Indeed, after the revision of our commodity strategies, we revised as well our forecast for the Euro area, incorporating this new lower natural gas price forecast. They lowered the TTF target to 55 on average for this year in Euros and 37 from next year before we had 75 and 50. So it's a quite sizable change in the gas profile.

And gas, of course, is a key input for our forecast here in Europe. So with this slight gas profile, our inflation forecast in the Euro area moved to 2.9% this year and 1.9% next year. So that's 40 basis point of cut this year and 20 basis point of cut next year.

For core inflation, we have 2.2 this year and 2.1 next year. So that's about 10 basis points of cut for both years. The new gas profiles are affecting headline inflation through gas and electricity, but also core inflation through some indirect effects and also accounting for the effects on growth.

The second hand effects via wage growth are more limited too, compared to what we had with the more aggressive energy price assumptions. But in any case, we were not assuming particularly strong second hand effects. The ECB is quite aggressive on that, but we don't agree much.

If you look at demand dynamics in hard data and also soft data, we're really not in a situation of 2022. So we are not that worried about very strong second hand effects. So in this new base case, the Euro area HICP peaks around 3.3 in the third quarter this year before we had a peak in the fourth quarter around 4% driven mostly by gas.

Then we see inflation falling below 2% again in the second quarter of next year with very strong negative base effects, of course, that will kick in in the second quarter of 2027. For core inflation, we think it will remain above target and it will go back close to 2% only at the end of next year. Thanks a lot.

Does this mean that June is still nailed on, a June hike from the ECB? Could they look through this now with this milder inflation profile? It's a good question.

We decided to keep our ECB call unchanged for now, but the risk balance has changed a little bit. We still expect two hikes, so June and July 2026, 25 dips, each one to a deposit rate of 2.5. There is some risk of a delay of the second hike to September.

For June, we remain quite convinced that it's almost a done deal hearing what ECB speakers have been saying and looking also at the most recent data. One key point is also that a couple of hikes were already included in the March ECB forecast assumptions. So not to do that, the ECB will need to be surprised to downside quite a bit, which doesn't seem to be in the cards right now.

In the second quarter, the ECB has a core inflation forecast of 2.2%. We think it would probably be above that. So it's going to be a little bit tough for the ECB to retract in such a clear way from the hikes.

That said, we remain convinced that the ECB will not hike more than twice. We think two hikes is kind of an upper bound. We also expect the ECB to cut next year quite quickly, quarterly cuts starting in June 2027, going back just below 2%.

They could even start reversing the hikes a little bit earlier than that, but we think they will want to see some clear evidence of inflation, including core inflation, being past the peak before cutting. And also they would want to be sure that there are no tangible second round effects. So that's why we keep June 2027 as the start of the cutting cycle that will follow the hikes of this year.

That's great. Thanks. And on the UK, we had Bailey speaking again today, they seem very reluctant to hike.

Do you expect a lower inflation peak now? For all UK economists, Sonali lowered the inflation forecast for the UK by 20 bps this year and 10 bps next year for the same reason that we've seen here in the Euro area for the lower gas price forecast. So now she has 3.3% inflation this year and 2.4% next year.

Core at 2.8% this year and 2.2% next year. The forecast was cut because of softer gas prices, but also due to the weaker than expected print that we got in April. In terms of peak, Sonali expects a peak at 3.7% in the fourth quarter of this year compared to 4.1% before with the old gas prices.

And she thinks inflation will fall slightly below the target in the second half of next year. The lower gas price forecast will cut headline inflation from July onwards when the July price caps reset and also indirect effects will lower core inflation slightly. In terms of the near-term path in UK inflation, the April print is likely to represent the low point.

From here, the path is likely up, energy prices are likely to lead to a pick-up in inflation in the coming months. The gas bills are due to rise in July, and also the indirect effects should become a little bit clearer in the next print. And in addition to that, some of the downside of the inflation print of April was probably driven by some erratic components like airfares and package holidays.

So Sonali expects that to reverse. That's great. Thanks a lot.

In terms of our expectations for the Bank of England on hiking, what will be key will be things like the decision-maker panel number next week. But we moved out of our view for the next hike from June to July a few weeks ago, and with a further hike in September. But we do have to reflect on the fact that the Bank of England do seem rather reluctant to hike and could easily decide to look through this inflation.

Very quickly, to finish on the inflation markets in the Eurozone and the UK, I mean, the inflation profile that's priced in the market for the Eurozone inflation seems fairly reasonable to us. I mean, five-year, five-year inflation at 214 looks like a sensible element of like a sliver of inflation risk premium. But what doesn't look right is five-year, five-year real rates, which are up at 92 basis points.

That leaves us structurally bullish on the European bond markets in general. We do think that's too high, way above our perceptions of what constitutes neutral. And these real rates should, we think, come down through the summer, thanks to a favorable supply and demand balance.

As far as the UK goes, what's interesting about the UK is, you know, the experience from the last inflation shock is the UK does struggle with an inflation persistence problem. So what is interesting is if you look at the impact of the conflict on the inflation profile for the UK, the Eurozone, and the US, and look at the kind of, the N2027 print. So the market expectations for N2027 for UK RPI inflation are only up eight basis points.

For the US, they're up 26 basis points. For Europe, up 46 basis points. So there's a degree of inflation persistence from this conflict that's greater for those other markets than the UK, and that's somewhat counterintuitive to me.

Thanks for joining us today. We hope you found this useful and that you'll tune in next week. Bank of America and B of A Securities are the marketing names for the global banking businesses and global markets businesses, which includes B of A Global Research of Bank of America Corporation, lending derivatives, and other commercial banking activities are performed globally by banking affiliates of Bank of America Corporation, including Bank of America N A member FDIC securities, trading research, strategic advisory, and other investment banking and markets activities are performed globally by affiliates of Bank of America Corporation, including in the United States, B of A Securities Inc, a registered broker dealer and member of FINRA and SIPC, and in other jurisdictions by locally registered entities.

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