Focus
October 01, 2021 | 13:29
U.S. Inflation Risks Inflating
Economics
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
U.S. Inflation Risks InflatingThe FOMC’s latest Summary of Economic Projections showed higher median forecasts for inflation than in June (Table 1). The revisions to this year were mostly a recalibration given the past three months’ performance. In July (the latest available data at the time), total PCE inflation increased to 4.2% y/y from 3.6% three months earlier, with core inflation at 3.6% versus 3.1%, owing to pressures from reopening along with the mix of strong demand and constrained supply. Consequent “bottleneck effects have been larger and longer-lasting than anticipated”, according to Fed Chair Powell in the post-meeting presser. |
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However, the revisions to next year, and in 2023 for the core, suggest that some of these “effects” are expected to endure more than previously presumed. It’s noteworthy that despite the higher inflation projections, the same 72% of participants as in June (13 of 18) still saw the risks to their inflation forecast as weighted to the upside. Powell said: “As the reopening continues, bottlenecks, hiring difficulties, and other constraints could again prove to be greater and longer-lasting than anticipated, posing upside risks to inflation.” We agree. In August, the total CPI increased 5.3% y/y after a two-month run at 5.4%, paces last seen in 2008 (Chart 1). Core CPI inflation was 4.0%, down from June’s crest of 4.5% and the highest readings in more than three decades. It’s unclear whether these recent highs will turn out to be the pandemic peaks. Because of tame monthly changes during last autumn and winter, a benign pace of 0.20% would result in core inflation peaking at 4.6% by next February. Boosted a bit further by food and energy prices, monthly moves of 0.30% for the total CPI would see headline inflation peaking at 5.7% early next year. Afterwards, through the spring of 2022, annual inflation rates should fall sharply owing to relatively high monthly changes a year earlier. However, we suspect some of the risks Chair Powell was referring to are going to be realized in the period ahead, pointing to even higher inflation peaks early next year and acting as restraints during the subsequent climb down. Indeed, there are already early signs of inflation pressures proliferating. Both the median and trimmed-mean CPI metrics have been accelerating, reflecting more diffuse increases among the index’s components (Chart 2). In August, the median CPI posted back-to-back gains at or above 0.3% for the first time since 2008. The trimmed-mean CPI registered five straight monthly moves at or above 0.4%, a level and consistency not seen for more than three decades (apart from a two-month run in 2008). Below, we discuss some of the major upside risks to inflation. Food prices (both at and away from home) have increased in the 0.4%-to-0.8% range for the past five months or at a 6.7% annualized rate. The latter is the fastest clip since the Great Recession, apart from a couple months at the onset of the pandemic. Demand has been strong and is expected to remain solid. The combination of real outlays on groceries and eating out has grown at a 5.7% annualized rate since before the pandemic (February 2020), the strongest growth over such an interval since the mid-1970s. Meanwhile, supply bottlenecks in this sector are being exacerbated by the shortage of truck drivers and extreme climate events around the world. The U.S. Drought Monitor estimates that 63% of the continental U.S. is currently grappling with abnormally dry weather and 48% with drought conditions (23% with the worst, “extreme” or “exceptional” drought conditions). This is impacting grain crop yields, which is exhausting stockpiles and hoisting prices higher. The price gains have been particularly profound for feed grains causing livestock herd sizes to be culled. It takes time to rebuild herds and stockpiles, even if the weather cooperates. Overall, prices received by farmers have been posting 22%-plus annual gains since April, the fastest clip over a five-month period since at least 1990. This mix of strong demand and constrained supply makes |
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The annual change in CPI energy prices has been running at 25% for the past five months. During September, both WTI crude oil prices and Henry Hub natural gas prices have continued to escalate (now above $75 and $5.70, respectively) pointing to additional upward pressure on consumer costs. Domestic supply bottlenecks in the energy sector have been exacerbated by surging air conditioner use with this year matching 1936’s Dust Bowl as the hottest summer on record (and the heatwave was a global phenomenon). And, recent supply disruptions ranged from the shutdown of Colonial Pipeline’s system owing to a cyber attack to the shut-in of Gulf of Mexico production owing to Hurricane Ida. The latter production is moving back to pre-hurricane levels and, short of an early or abnormally cold winter, energy prices should soon stabilize and eventually recede (for the record, we look for WTI to average $70 next year with Henry Hub at $3.00). However, the ebbing of energy prices could prove to be volatile owing to global developments beyond the vagaries of OPEC+. Market conditions in Europe and Asia are resulting in much higher natural gas prices, prodding LNG activity. Meanwhile, the global decarbonization push and rising carbon prices will impact oil and gas prices over time, along with the supply-constraining impact of investors’ increasing ESG scrutiny. |
Shelter costs: So far this year, rent increases are averaging 1.9% y/y (it was 2.1% in August alone), setting up the smallest yearly gain since the 1960s apart from the Great Recession and its aftermath. However, the rental vacancy rate, at 6.2% in 2021Q2, is sitting at its second lowest level in 37 years (2020Q2 was the lowest at 5.7%). One factor driving the disconnect could be the pandemic’s eviction moratoria; they dampen rental unit turnover and repricing. However, while some state and local moratoria linger (although most end by October), the federal government’s attempt to extend theirs was denied by the Supreme Court on August 26. We could be in store for some catch up rent increases given industry reports of recent acceleration. For example, monthly increases in Zillow’s Observed Rent Index have run in the 1.5%-to-2.0% range during the five months ending August, and they have never topped 1% before (back to 2014). |
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Owners’ equivalent rent (OER) was up 2.6% y/y in August. This imputed figure is based on actual rents adjusted for embedded utilities costs. And, it’s influenced by home prices, with a lag of around 1½ years (Chart 4). Fuelled by the recent run-up in natural gas prices, utility costs are currently increasing at their second fastest clip (8.6% y/y) in more than a dozen years, applying a temporary damper on OER. Meanwhile, in July, the S&P CoreLogic Case-Shiller Home Price Index was up a record 19.7% y/y. Around 1½ years ago home price inflation was well under 5%, pointing to a rapid OER rise. Global microchip shortage: With past production problems at some existing facilities being fixed and new capacity coming on stream, it’s generally judged that this shortage will mostly be remedied as 2022 unfolds. In the meantime, it will continue to act as a supply constraint for a wide array of chip-embedded goods such as vehicles, household appliances and personal electronics—keeping their prices higher than they otherwise would be. In August, new vehicle prices were up 7.6% y/y, the most since 1980. The CPI prices of information technology commodities are quality adjusted and, as such, usually register reductions. However, the prices for computers, peripherals and smart home assistant devices, after falling for 23 consecutive years, will likely rise in 2021. The August advance alone was 3.4% y/y. Producer prices: Further up the production pipeline, producer price inflation was still hitting new highs in August and at paces surpassing those on the consumer side. Final demand prices (both goods and services) were up 8.3% y/y with those for personal consumption up 7.4%. Meanwhile, the prices of production inputs along with workers’ wages and transportation costs continue to be impacted by bottlenecks and shortages. These are applying further upward pressure on producers’ ending prices and, to the extent they can be passed along, on consumer prices. For example, the prices of intermediate goods (materials, supplies and components) were up 23.0% y/y in August, the most since 1947 apart from an eight-month run in 1974/75. Crude goods prices were up 50.1%, after hitting an all-time high of 59.4% in April. Elsewhere, shipping container costs spiked above 485% y/y in early August (now under 340%). |
Despite escalating wage costs in some industries (e.g., food services) and lots of big-name companies raising their base rates, there has yet to emerge compelling evidence of broad-based (economy-wide) wage pressures. However, it’s likely only a matter of time before the already evident upward pressure on the wages of younger and lower-skilled workers spreads to their older and higher-skilled cohorts, given job vacancies. Job openings hit a record 10.9 million or 6.9% of payrolls in July, with a record-high 50% of small businesses plagued by unfilled positions in August. Pricing behaviour: Firms are increasingly feeling that they can pass along their cost increases to their customers. Among small businesses in August, a net 49% are currently raising prices and a further 44% plan to continue doing so, both the highest shares in more than four decades (Chart 5). Why are firms so emboldened? Well, demand is strong, supply is constrained and, importantly, cash is abundant. |
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The willingness of consumers to pay higher prices for many goods and services could last a lot longer than anticipated as they sit on the mountain of savings accumulated during the pandemic. Along with accumulated business savings, there is currently an extra $3.6 trillion (15.9% of GDP) parked in bank deposits and retail money funds, above what the pre-pandemic trend would imply. As this cash is deployed, the demand side of the bottleneck equation could last longer in the face of higher prices, which, in turn should stoke further inflation pressure. One can’t help hearing Milton Friedman’s famous phrase that “inflation is always and everywhere a monetary phenomenon”. Bottom Line: The FOMC lifted its inflation forecasts because “bottleneck effects” were turning out to be more enduring. The inaugural median projection for 2024-end was 2.1%, which aligns with the Fed’s new framework to aim for “moderately above 2% for some time”. However, given the array of upside risks to inflation lurking on the horizon, ensuring 2.1% might require more than the FOMC’s median call for 162.5 bps of cumulative tightening by then. |