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How Transitory Is The Inflation Problem Ahead?
This evening, Reuters reports that ship traffic through the Strait of Hormuz was well below 10% of normal volumes on Thursday, despite the US-Iran ceasefire. Tehran asserted its control by warning ships to remain within its territorial waters as they passed through the Strait to avoid mines. As we've noted previously, geopolitical crises tend to provide buying opportunities in the stock market. Sure enough: Following a 9.1% pullback from January 27 through March 30, which occurred mostly in March because of the war, the S&P 500 is up 7.6% through today's close, led by a 9.6% rise in the Magnificent 7. Stock investors are clearly betting that the hot war will continue to cool off. That's been our bet since late Tuesday, March 31, when we wrote that the market probably bottomed the day before. On the other hand, we think that bond investors should be more concerned that inflation was heating up just before the war, and now will continue to do so, probably through the end of this year. We are still counting on productivity to offset the war's inflationary consequences. But we are on alert. Here's why: Pre-War Inflation During January and February, the two months before the war, the CPI inflation rate was slightly cooler than expected at 2.4% y/y in both months. However, both the headline and core PPI inflation rates were hotter than expected. So was import price inflation, which was expected to moderate as the effects of Trump's 2025 tariffs wore off. Today we learned that the headline and core PCED price indexes both rose 0.4% m/m in February. On a year-over-year basis, both measures stopped falling and stalled around 3.0% (above the Fed's 2% inflation target) over the past year as Trump's tariffs boosted goods prices, especially durable goods prices (chart). Services inflation continued to moderate, led by cooling shelter inflation. Last year, the Fed tolerated the lack of progress toward its 2% target because the inflationary impact of tariffs was widely expected to be transitory. Moderating services inflation was cited as evidence that underlying inflationary pressures were easing. Fast forward to February 2026, and the assumption about tariffs has yet to be vindicated. Durable goods inflation surged 1.1% m/m in February–the strongest monthly reading since January 2022. It is up from -3.1% y/y in May 2025 to 2.8% currently. The March FOMC meeting Minutes confirmed that policymakers still expected the inflationary impact of tariffs to fade over the course of this year. According to the Minutes, "participants generally expected that the effects of tariffs on core goods prices would diminish this year." Post-War Inflation Fed officials seem to have the same transitory assessment of the latest energy price shock, which is very similar to the one during 2022. Back then, inflation began rising in 2021 due to pandemic-related supply chain disruptions. The energy price shock exacerbated inflation and forced the Fed to raise interest rates more aggressively after it realized the inflation problem was more persistent than expected. This time, the energy shock is hitting while inflation has remained stuck around 3.0% due to tariffs, which are having a more persistent inflationary impact than Fed officials might have expected. Tomorrow morning's release of the March CPI will undoubtedly show that the energy price shock is boosting energy-related inflation. The risk is that the shock will boost inflation more broadly in the coming months. Consider the following: (1) In 2022, a surge in jet fuel prices translated directly into a spike in the CPI for airline fares. It is doing that again. (2) A surge in WTI crude oil prices translated into a spike in the CPI for transportation services back in 2022. It is doing that again. (3) The bottom line is that there is a risk that inflation will turn out to be more persistent than widely expected, including by Fed officials, once again. If so, then beware of an adverse reaction from the Bond Vigilantes once they wake up from their siesta. We are still using a 4.25%-4.75% range for the 10-year Treasury yield this year. We are at the bottom of that range now, but thinking that the next move might be to the top end.
Read Full AnalysisOn Health Care, Energy Inflation & Small Nuclear Reactors
The S&P 500 Health Care sector is showing signs of a rebound following a period of significant underperformance. Jackie examines the recent surge of large drug companies buying biotech upstarts and the surprise increase in Medicare reimbursement rates for 2027. ... The cease-fire between the US and Iran sent the price of Brent crude oil futures tumbling 15%, providing some much-needed relief for airlines and shippers which have been aggressively passing higher fuel costs to consumers. ... Meanwhile, the race to build AI data centers is accelerating interest in Small Modular Reactors despite one project cancellation and pending regulatory approvals. We look at some of the major projects being planned across the country by X-Energy Reactor, NuScale Power, Oklo, TerraPower, and Holtec International.
Read Full AnalysisAs Yogi Said: 'It Ain't Over Till It's Over' & 'It's Déjà Vu All Over Again'
The fog of war has been replaced by the fog of the ceasefire between the US and Iran. Negotiators for the two countries will meet in Islamabad on Friday. They met many times before without averting the war. The pounding of Iran by the US and Israel has failed to topple Iran's regime, which still seems to have firm command and control of the country despite the decapitation of its leadership during the first day of the war. The Islamic Revolutionary Guard Corps remains intact, capable of firing missiles and drones, and has effectively taken over the Strait of Hormuz. The American negotiators will still insist that Iran abandon its nuclear program and surrender its stash of enriched uranium. But now they also need to get the Iranian regime to reopen the Strait as a free passageway for navigation in accordance with international law. Given all the above, today's latest relief rally in the stock market might have reflected more short covering than outright buying. Still, it was impressive to see the S&P 500 rebound back above both its 200-dma and 50-dma (chart). Moreover, during the 9.1% pullback since January 27, the 50-dma has remained above the 200-dma. We still think that the S&P 500 bottomed on Monday, March 30, at 6343.72. It is up 6.9% since then and down only 2.8% from its record high on January 27. At the start of this year, we expected the stock market to be choppy in the first half, though we didn't anticipate the war. It is likely to remain choppy until ships can sail freely through the Strait. The rebound in stock prices today was fueled by a sharp drop in crude oil prices after President Donald Trump postponed Obliteration Day yesterday, a couple of hours before his 8:00 p.m. deadline for Iran to open the Strait. Nevertheless, both Brent and WTI prices remain elevated tonight, just below $100 a barrel. They were closer to $70 just before the war (chart). For the Fed, it is déjà vu all over again. Oil prices soared in 2022 after Russia invaded Ukraine. That led to a surge in inflation. However, back then, the CPI goods inflation rate was already rising due to supply-chain disruptions (chart). This time, tariffs boosted CPI durable goods inflation over the past year. No word haunts the Fed more than the word “transitory.” It was used by Fed officials to describe the surge in inflation triggered by pandemic-related supply chain disruptions in 2021. In 2022, with inflation still rising, Fed officials scrambled to tighten monetary policy and were subsequently roundly criticized for their tardiness and for it being a major policy error. The jump in oil prices exacerbated the inflation initially caused by the pandemic. In today's Minutes of the March 17-18 FOMC meeting, the word transitory doesn't appear even once. Instead, the participants of the Committee seemed resigned to missing their inflation target for a while longer: "The vast majority of participants noted that progress toward the Committee's 2 percent objective could be slower than previously expected and judged that the risk of inflation running persistently above the Committee’s objective had increased." Oh well: Inflation has exceeded the Fed's 2.0% target for five years and one month now. What's a few more months or a couple more years? Several participants took some comfort in "that most measures of longer-term inflation expectations remained consistent with the Committee's 2 percent objective." That's not exactly so, based on the March readings of around 3.0% for 3-5 years expectations, according to the FRBNY consumer survey (chart). The overriding message from the Minutes was neither hawkish nor dovish. It was one of deliberate patience. "All participants agreed that monetary policy was not on a preset course and would be determined on a meeting-by-meeting basis." This echoes Powell's March press conference, where he emphasized that policy is “in a good place” and that it is best to wait and see how the Middle East conflict evolves. That appears to be the consensus view. A rise in long-term inflation expectations, or second-round effects from energy prices into core inflation, might trigger a hawkish response from the FOMC. For now, the Fed is set to remain on the sidelines consistent with our "none-and-done" outlook for Fed policy in 2026. The federal funds rate futures market agrees with us for now (chart).
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