This week's U.S. CPI release was much stronger than expected. Headline inflation (measured as the % year-over-year change in the CPI) was at its highest level since September 2008 and core CPI inflation (excluding food and energy) the highest since 1996. This has reinforced fears of a return to the stagflationary conditions of the 1970s, when the combination of high unemployment and high inflation coexisted for several years. Rising commodity prices, supply chain problems (such as semiconductors), declining global trade and trade rigidities resulting from Covid restrictions are cited as reasons why we should be concerned that the rise in inflation is more than transitory.

There are a number of points to keep in mind regarding the published data:

1. Inflation was expected to rise sharply anyway in April due to the base effect: year-over-year comparisons are easy for April and May because the CPI experienced a large drop this time last year. This effect will disappear in the coming months.
2. The impact of the base effect will peak in May, after which it will diminish as the year progresses, so if inflation remains elevated, it will be for other reasons. The May CPI report will be released on June 10, so market nervousness about inflation is likely to continue for the next couple of months at least.
3. Data are revised often. Given the unusual circumstances of the past year, revisions are likely to be quite significant. Yesterday's impact may turn out to be less once the final data is released.
4. The June CPI report will be released on July 13. Only then will it be clear to what extent the higher inflation has been driven by the base effect or other factors. However, uncertainty will remain. Only if inflation falls rapidly and remains low thereafter will fears abate.
5. While our fundamental view is that inflation will fall back to levels consistent with the Fed's targets, upside risks have increased.
6. Central banks have struggled for at least the last decade to raise CPI inflation despite exceptionally accommodative monetary policy. It is somewhat ironic then that now that some inflation has returned, jitters are running high. While there may be some near-term jitters, inflation that is structurally a bit higher over the next 10 years than it has been over the last 10 would be no bad thing. For example, it would help reduce the real debt burden: government, household and corporate.
7. Several Fed governors and regional bank presidents have reiterated a consistently dovish message over the past few months. Even if inflation is a bit above target, that is not of great concern, especially now that eight million fewer people are employed than in the pre-Covid peak. In addition, the Fed has emphasized the importance of the distribution of unemployment among the different strata of U.S. society, something that also offers a high degree of flexibility.

The risks of persistently higher inflation have certainly increased recently, and it is natural to be concerned that the temporary factors driving inflation higher will not decline as much as pure statistical models indicate. However, our expectation is that inflation will slow to more comfortable levels in the second half of the year. This will not become apparent until mid-July. Until then markets are likely to be sensitized to the perceived news flow supporting the high inflation assumption. If we are wrong and inflation is persistently higher, we expect the Fed to be patient in withdrawing stimulus.