Market Extra: Why financial markets may be unprepared for a fourth-quarter ‘inflation surprise’

Bill Pugliano/Getty ImagesA prolonged strike by the United Auto Workers, who could walk out next week, is being seen as one big factor that could contribute to upside inflation risks through year-end and upset financial-market expectations.Joseph Kalish, chief global macro strategist, and research analyst London Stockton of Ned Davis Research, see the potential for a stretched-out strike to push up new and used vehicle prices, and encourage other workers to demand more compensation. They’ve added emboldened unionized labor, along with rebounding medical costs, to the list of factors which could contribute to “an unexpected inflation surprise” in the fourth quarter and “keep the Fed in play before the year is over.”Read:Stock market’s 2023 run may hit roadblock after August’s energy-led boost to U.S. CPI and United Auto Workers reject GM counteroffer — and say ‘the clock is ticking’ for potential strikeHigher oil prices aren’t the only problem facing the U.S. when it comes to inflation, and financial markets may not be fully prepared for a scenario in which price gains don’t meaningfully budge from June and July’s levels of around 3%, based on the annual headline rate from the consumer price index. Fed funds futures traders, for example, are mostly expecting no further action by policy makers this year and see a decent chance of interest rate cuts beginning next May or June. Moreover, stocks DJIA SPX COMP are still posting year-to-date gains, in contrast to 2022’s dismal performance for equities.“There seems to be a lot of complacency in the markets and from policy makers thatinflation will continue to drift down toward the Fed’s 2% inflation target over the next couple of years,” Kalish and Stockton wrote in a note on Friday. But after crude oil touched 2023 highs this week, they said that “the rise in energy prices will not only have a direct impact on inflation, it will propagate through to other goods and services.”Market-based expectations for future price gains have remained relatively stable despite the run-up in oil prices, though inflation traders are now bracing for five straight months of 3%-plus readings in the annual headline CPI rate, including the one for August that’s set to be released on Wednesday.A long strike by 146,000 UAW workers at the “Big Three” U.S. automakers — General Motors GM, Ford Motor F, and Chrysler — has the potential to send auto prices “soaring,” according to Kalish and Stockton. Meanwhile, the fourth quarter is likely to usher in a reversal in pricing for medical care, a change which could have a greater impact on the Fed’s preferred inflation gauge known as the personal consumption expenditures price index, they said. “Nobody who has gone to the doctor in the past 12 months believes prices have retreated.” Derek Tang, an economist at Monetary Policy Analytics in Washington, said “there’s been a lot of talk about things being at an inflection point, whether it be inflation falling or policy makers who could stop rate hikes. But that’s very hopeful and could turn out to be wishful thinking.”“We still have an economy that’s super strong and resilient,” Tang said via phone on Friday. “I’m especially thinking about wage growth being stubborn, which could sow the seeds for inflation further down the road. The Fed is hoping for inflation to fall away, but we don’t have a framework for thinking about what happens in a stubborn-inflation scenario in which inflation is stuck at 3%.”

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