Inflation is running at a 40-year high. What does it mean for I Bonds, TIPS and future interest rates?
By David Enna, Tipswatch.com
Once again, U.S. inflation is running higher than expectations, a trend that will probably continue through the early months of 2022.
The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.6% in January on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all-items index increased 7.5%, the largest 12-month increase in 40 years, since the period ending February 1982.
Both the monthly and year-over-year increases exceeded economist expectations of 0.5% for the month and 7.3% for the year. Core inflation, which removes food and energy, also exceeded expectations, running at 0.6% in January (versus expectations of 0.5%) and 6.0% for the year (versus 5.9%). The year-over-year number for core was the largest 12-month change since the period ending August 1982.
And this jump higher in inflation came despite the fact that gasoline prices actually fell in January, a trend that is likely to reverse in coming months. The BLS noted that a wide range of price increases contributed to January’s surge in inflation. Some highlights:
- Food-at-home prices increased a troubling 1% in the month, and are now up 7.4% over the last year.
- Gasoline prices fell 0.8% for the month, but are up 40% over the last year. This decline is highly likely to reverse in future months, as the price of WTI Crude has increased about 35% in the last two months.
- Shelter costs rose 0.3% for the month, and are up 4.4% over the last year. This is another category where higher prices can be expected into the future.
- Costs of electricity surged 4.2% in the month and are up 10.7% year-over-year.
- Apparel prices, once a sleepy sector in the CPI report, were up 1.1% in January.
- Prices for used cars and trucks continued surging higher, up 1.5% in the month and 40.5% for the year.
- New car prices held stable, but are up 12.2% for the year.
- The medical care index rose 0.7% for the month.
To wrap things up, the BLS said this: “The increase is broad-based, with virtually all component indexes showing increases over the past 12 months.”
Here is the one-year trend for all-items and core inflation, showing the remarkable climb higher from very low levels of inflation in January 2021:
What this means for TIPS and I Bonds
Investors in Treasury Inflation-Protected Securities and U.S. Series I Savings Bonds are also interested in non-seasonally adjusted inflation, which is used to adjust principal balances on TIPS and set future interest rates for I Bonds. For January, the BLS set the inflation index at 281.148, an increase of 0.84% over the December number.
For TIPS. The January inflation report means that principal balances for all TIPS will increase 0.84% in March, following an increase of 0.31% in February. For the year ending in March, TIPS principal balances will have increased 7.5%. Here are the March inflation indexes for all TIPS.
For I Bonds. The January inflation report is the fourth in a six-month series that will determine the I Bond’s new inflation-adjusted variable rate, to be reset on May 1 based on non-seasonally adjusted inflation from September 2021 to March 2022. So far, with two months remaining, inflation has increased 2.49%, which would translate to an I Bond variable rate of 4.98%. Two months remain, and that rate is likely to climb higher. Here are the data so far:
What this means for future interest rates
Clearly, interest rates are heading higher. This inflation report continues a string of higher-than-consensus numbers, even though the consensus forecasts have been rising. Already this morning the 10-year Treasury note is trading with a yield of 1.98%, very close to breaking through the 2% barrier, a level we haven’t seen since July 2019. And stock market futures are falling, indicating the markets are again adjusting to a future with higher interest rates.
From this morning’s Wall Street Journal report:
High inflation is the dark side of the unusually strong economy, posing a challenge to the Federal Reserve as it tries to quell rising prices without damping growth.
“This is not encouraging news for the Fed in its battle to get inflation heading back towards the 2% target,” said James Knightley, chief international economist at ING. “Rate hikes will do nothing to resolve supply chain strains and worker shortages, but they can contribute to taking some of the steam out of the economy and allow demand and supply to start moving towards a better balance, at the expense of weaker growth.”
I’m sure the Federal Reserve has a very good idea where prices are heading, and the current trend of 40-year inflationary highs must be addressed. An easy prediction: Expect the Fed to begin raising short-term interest rates in March, and continue raising them through 2022.
What will happen to longer-term rates? That will depend on the economy and the stock market’s reaction to Fed actions. In the next few months, longer-term rates should climb higher, but possibly stabilize if the economy begins sinking or the stock market plummets.
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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.