Stocks Can Handle Inflation For Now

The stock market should continue to recover from last week's inflation shock be for several reasons.  /1/ The Fed is likely to remain on its gradual tapering path, which could be reiterated by some Fed speakers this week. One inflation report will not change Fed policy.  And, Powell will likely want to maintain a stable policy while Biden is deciding whom to nominate as Fed Chair.   /2/ Economic growth is strong.  Even if growth moderates ahead, which is a possibility, it would be positive for stocks by holding down inflation.  /3/ Much of the jump in the October CPI is attributable to temporary factors.  And, a main underlying culprit -- oil prices -- appears to have stabilized for now.  So, the Fed can wait and see.  Nevertheless, the inflation risk remains as long as economic growth is above trend and pushes down the Unemployment Rate.

The very high October CPI likely overstated the trend in inflation.  About half of the 0.6% m/m jump in the October Core CPI resulted from /1/ Used Car Prices (+2.5%), /2/ New Vehicle Prices (+1.4%), /3/ Medical Care Services (+0.5%) and /4/ Recreational Services (+0.8%).  The run-up in car prices should reverse once the chip shortage abates.  Medical Care Services Prices are volatile on a m/m basis.  And, the jump in Recreational Services reflected an 8% jump in Admissions to Sporting Events, which is not likely to be repeated in coming months.

In addition to the easing of temporary factors, a moderation in price inflation is conceivable considering the underlying reasons for the speedup:

 /1/ Some of the increase in inflation could be just a one-off adjustment to the re-opening of the economy -- and this factor should end soon.  The shortages and bottlenecks stemming from the speed of recovery should work themselves out in coming months. 

/2/ The pass-through of higher transportation costs -- reflecting higher fuel costs and a trucker shortage -- is likely a major reason for the run-up in food and other prices.  Oil prices rose sharply as OPEC held back production relative to demand and as the Biden Administration pushed against lifting US domestic oil/natural gas output.  The Administration may have influenced the OPEC decision, as well, by moving against Saudi Arabia in a number of ways and moving favorably toward Iran, Saudi's enemy.  The OPEC decision could have been in retaliation or a snubbing of the US.   Oil prices have stabilized at this point.  But, some Saudi officials have been reported seeing the potential for these prices to climb to $150/bbl.  Perhaps the possibility of a cold winter is behind this potential.

/3/ The extended Unemployment Benefits most likely kept some people from taking jobs, thereby pushing up wage inflation.  While the Democrats might think boosting low-paid workers' wage rates was a good result, the pass-through of these higher wages to prices undercut the real benefit -- as reflected in the drop in the University of Michigan Consumer Sentiment Index.  With the extended Unemployment Benefits expired, labor costs could moderate in coming months and hold down price inflation. 

But, the risk of higher inflation remains as long as economic growth is above trend.   At 4.6%, the Unemployment Rate already may be below the Non-Accelerating Inflation Rate of Unemployment (NAIRU) -- the level of the Unemployment Rate below which inflation accelerates steadily.  NAIRU had been estimated to be in the mid-5% range before the Trump years.  But, even if NAIRU is lower, the Fed is aiming for the Unemployment Rate to fall to the pre-pandemic low of 3.5%.  A further tightening of the labor market will likely move the Rate closer to if not below NAIRU and boost wage inflation.