The US Fed wants to see real-time data on impact of tariff hikes, although likely a bit delayed due to reasons we previously discussed. June CPI data showed some signs of this in household furnishing, apparel and recreation goods. The Fed has also reiterated its job is to prevent second round or long-term impact. In this context, we look at US inflation expectations of the swap market (figure above). While this reflects the impact of tariffs, other factors & market-specific aspects, the move from early this year is noteworthy.
- Data showed a pickup in 1-year expected inflation from February till end-June, while 2y stayed flattish. This implies expected rise in inflation was in the first year, indicating hardly any second-round effect.
- From July, both 1y and 2y expectations have picked up, although the former has risen more. This suggests markets are now a bit more worried about persistence of tariff passthrough to prices (if seen alongside the reacceleration in tariff talks) and/or reflects the impact of the tax cut bill being passed.
- Second-round effects, through wages and prices, is typically meaningful when the consumer situation is robust. The Fed believes current labor market conditions are solid, but we think it could be weaker under the hood. Services consumption growth has also weakened. Auto loan and credit card delinquencies have been rising, and student loan related payments and credit score impact is back. Lower income quartiles and non-asset owners were already not doing well, and various studies suggest a disproportionate negative impact on them from both tariffs and tax cuts. The strength of second order effects is thus a question in such an environment.
Given the Fed’s approach, longer-term inflation expectations from surveys of consumers/businesses/professional-forecasters, and market-based measures need to be closely watched.
Source for the chart: Bloomberg, Bandhan MF Research. Note: Chart depicts inflation expectations derived from inflation swaps.
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