There are two takeaways from the March Business Inflation Expectations survey: 1) business inflation expectations for firms in the Sixth District accelerated again in March (i.e., no sign of a reversion yet, which raises the risks of another upside surprise to the March CPI report), and 2) the jump in unit costs is pressuring margins.
The NFIB measure of small business earnings has also been trending lower since the peak in May 2018. These two measures combined suggest that the outlook for corporate profits is less than rosy and that high inflation is taking its toll.
Smaller businesses have suffered an adverse outsized impact from the current inflation spike. When margins are falling, there is less scope to absorb price increases, which are subsequently passed onto consumers.
Despite the rise in longer-term business inflation expectations, the FOMC projections showed a drop in the longer run estimate of the Federal Funds rate from 2.5% to 2.4%. At the same time, FOMC participants shifted up the dot plot for this year and the next. The yield curve is flattening in response, even as Treasury yields rise across the curve. The 10-year yield was back up to 2.24% this morning. However, the 2-year yield breached 2.0% again. The bond market appears to be warning that the economy will not take higher interest rates.
The lowering of the longer-run estimate of the Federal Funds rate is nothing new for the FOMC: it has been revised down steadily over the past decade. But with longer-term inflation expectations on the rise, even if modestly, the FOMC projections are pointing to an even lower r*. They are, in effect, forecasting a continuation of the secular downward shift in real interest rates, which is not assured.
