February 12, 2021 | 13:00
Inflation is everywhere it seems, except in the data. Amid the many moving parts, the dominant market theme so far in 2021 has been the reflation trade, which has lifted equities to record highs, 10-year bond yields to well above 1%, and commodities to above year-ago levels. This move has been driven by the view that vaccines will support a robust global economic recovery, with prospects of another big booster shot of U.S. fiscal stimulus piling on. In turn, this has lifted inflation expectations, with markets now pricing in average annual U.S. price gains of more than 2.2% over the next decade, or well above pre-pandemic norms. Yet, despite this broad market move, the inflation facts on the ground aren’t quite keeping pace with lofty expectations.
U.S. CPI for January was the one key economic indicator in a light week for data and events, and it was a bit of a damp squib. To be sure, few are complaining about inflation remaining modest, but a second consecutive reading of flat core prices trimmed the annual underlying rate to 1.4% (from 1.6%). Typically, the Fed’s key gauge (core PCE deflator) is a few ticks lower yet, and that suggests a further move away from the 2% goal last month. True, headline CPI was up a meaty and expected 0.3%, but, again, the annual 1.4% overall inflation rate is going to scare precisely no one.
If anything, the U.S. is at the upper end of inflation trends among the major economies. True, the Euro Area showed a flash of price pressure at the start of the year, but the headline figure is still a tad below 1%. Meantime, China reported this week that consumer prices actually fell 0.3% y/y last month, with core printing the same number and reaching its lowest ebb since 2009. It’s a similar story in places as diverse as Japan and Switzerland, which are both still reporting negative headline inflation rates. Canada’s January CPI report will be highlighted in the coming week, and Wednesday’s result is likely to show inflation held just below 1%.
Amid this ultra-calm surface, there are two very large and very obvious factors barrelling down on CPI. First, oil prices have sprinted higher in recent weeks, along with a variety of other commodity prices (lumber, natural gas, to name just two). For example, WTI at nearly $59 is up more than $10 (or 20%) in the past six weeks alone. Gasoline prices are now up roughly 10% y/y, after posting big declines through 2020 (-16% on average), and still down 9% y/y in January. In Canada, the BOC’s commodity price index has soared 28% y/y to early February and is close to its highest level in six years (i.e., way back when oil prices were first coming down the mountain).
The second big factor, and it’s one we all knew was coming, is that prices two and three months from now will be compared with the extreme conditions of the lockdowns a year ago. At that time, gasoline and some other prices collapsed, so the year-on-year comparisons will be gaudy. Fed Chair Powell even addressed this potential future shock for CPI in his remarks this week at the New York Economics Club. He suggested that while we are indeed likely to see some hefty inflation readings in coming months, “they won’t mean that much”, since the lofty levels are unlikely to be sustained, in his view.
While we largely agree with Powell’s position, and expect inflation to ebb back to around 2.5% later this year, there are two mild concerns. One is that there is the real possibility that we haven’t seen the last of the gains in oil and other commodities. We have boosted our oil price assumption for 2021 to $55 (from $50), owing to the ongoing impressive discipline by OPEC+, but readily admit that this remains a conservative projection. Second, headline inflation readings of possibly almost 4%—even if for just a month or two—will be landing just as a wave of fiscal stimulus will wash ashore in the spring, along with a presumed rebound in U.S. activity as the vaccines roll out. It doesn’t require much imagination to see inflation expectations becoming a tad unhinged in that backdrop. U.S. consumers are already taking this rising inflation risk on board, as the latest University of Michigan survey of year-ahead inflation expectations jumped to 3.3% in February, up from 2.4% a year ago.
Canada is not immune to this risk. True, the vaccine boost will be much slower to arrive, and the fiscal support has been more spread out and consistently strong in this economy. But recall that inflation fell even further last spring in Canada, with headline inflation diving into negative terrain last April and May (while U.S. inflation bottomed at 0.1% in May). And, unlike the U.S. data, Canada’s raging housing market is beginning to make some noise in the CPI. From a standing start a year ago, housing replacement costs in the CPI have surged 5.5% y/y, the fastest pace in more than a decade. With home sales and prices flaring yet again last month (official data are out next Tuesday), it looks like this factor will continue to add some spice to what will already be some hot CPI readings in coming months.
But before overly stoking inflation concerns, let’s be clear that we are mostly in alignment with Powell’s view. One way to look through the coming inflation spike is to consider the annualized two-year rise in prices. This measure smooths out temporary ups and downs in energy (or other costs); and if the ups and downs are not temporary, then they shouldn’t be excluded from our overall view on inflation. Even if headline inflation pokes up to around 4% in the spring, the two-year metric will be close to 2% (and probably still below that in Canada), and that’s a much more realistic measure of underlying inflation. We could just focus instead on core inflation—the six-month trend in U.S. core CPI is a moderate 1.7% annualized. But even now, some of those measures remain frankly polluted by the highly unusual conditions of the past year. After all, what do hotel and airline prices really mean to most of us these days?
Bottom Line: The sustained strength in energy prices and the coming U.S. fiscal push look to add to what was already going to be some eye-popping headline inflation readings in the months ahead. But while high-side inflation risks have clearly risen, we believe that underlying trends will remain locked close to 2% when the dust settles. Just as a reminder, inflation expectations also surged in the early days of the past cycle (peaking above 2.5% in 2011), as oil prices revived and QE was a new thing—but the reality simply never lived up to the spike in inflation concerns.
Forecasters are rapidly adjusting their outlook on the U.S. economy as the outlook on fiscal policy adjusts. In just the past month, the Blue Chip consensus on U.S. GDP growth has been revised up by a whopping 0.7 ppts to 4.9%. The survey was conducted just this week, and more fully reflects the impact of the change in Senate control. We are a tad above consensus at 5% for this year, but have built in “only” around $1 trillion in additional stimulus. The average forecaster is assuming the final fiscal package will ultimately come in at $1.5 trillion (or about 7% of GDP, a massive tally), not far from Biden’s proposed $1.9 trillion.
Not to dig too deeply into the weeds, but the consensus assumes a multiplier from the new spending will be quite modest (the Q4/Q4 lift is projected at 1.6 ppts, so a first-year multiplier of little more than 0.2). If either the final package is even larger, or the multiplier on the new outlays is even greater (quite possible), then there is clearly still upside risk to the U.S. growth forecast this year. Note that some high-profile Wall Street forecasters are looking for GDP to sprint by well over 6% this year. To put that in perspective, the 6% annual growth hurdle has been cleared by the U.S. economy exactly once in the past 50 years—in 1984, GDP soared 7.2% amid a wave of fiscal stimulus after the deep early 1980s downturn.
Final point is that even as the consensus on the U.S. economy has been steadily grinding higher, the exact opposite trend has unfolded in almost every other major economy. For example, in the past six months, consensus GDP forecasts for 2021 have risen 0.9 ppts for the U.S. economy, but dropped 0.2 ppts in Japan (to 2.3%), by 0.7 ppts for Canada (to 4.6%), by 1.3 ppts for the Euro Area (to 4.4%) and by 2.2 ppts for the U.K. (to 4.2%). And, note that the U.S. reported a lighter 2020 GDP hit than any of these economies, and yet is also expecting a stronger gain in the coming year. Little wonder that the U.S. dollar’s long decline has at least been temporarily paused.