July 16, 2021 | 14:01
U.S. Inflation: Define Transitory
Neither the Fed nor bond investors seem all that fussed about inflation these days, despite some alarming data. After another eye-popping U.S. CPI report—which now has core prices up 10.6% annualized in three months, the most in four decades—we hiked our inflation forecast again, staying one step ahead of consensus. One or two months doesn’t make a trend, but three months suggests a pattern, and this one points to greater persistence. We now expect the annual CPI inflation rate to rise from 5.4% to 6.0% at the turn of the year and the core rate to rise one more percentage point to 5.5%, before retreating in tandem to 2.7% at the end of 2022. That compares with around 2.4% in early 2020.
It’s not just the recent speed of the increase that’s raising eyebrows (at least ours), it’s the breadth. More CPI items are flashing some real heat, beyond the services that are rebounding after pandemic plunges or the vehicles that were affected by chip shortages. Floor coverings, video and audio services, and lesson fees all jumped the most on record in June, while furniture, appliances, sporting goods and domestic services are up more than 5% in the past year. Low base-year effects only impact the recent sharp monthly increases to the extent that prices were slammed at the start of the pandemic, such as airfares, restaurant meals, and hotel rates, and are now rebounding quickly. There’s a little more lift left in airfares which remain 10% below pre-virus levels, though hotel charges are now actually a bit above. The CPI would be running even hotter if health care costs weren’t so benign (0.4% y/y), partly due to a reversal in health insurance costs after they shot up 39% in the two years to August 2020. As well, rents are subdued (2.6%), though surging house prices are bound to push more potential buyers into the rental market.
The core CPI is now running the fastest in three decades, though a third of the increase reflects surging auto prices. While used vehicle prices (45.2% y/y) reversed a bit in June, they could pressure the CPI for another month and jack up new vehicle prices (5.3%). Other measures of underlying inflation generally confirm the rising trend. The Atlanta Fed’s “sticky” CPI rate is near pre-virus levels after vending machine costs spiked the most on record in June. The index measures items that tend to change slowly, so a further increase could indicate more persistence. While the Cleveland Fed’s median CPI metric remains tame at 2.2%, the trimmed-mean measure is running at 2.9%. The latter, along with the New York Fed’s Underlying Inflation gauge at 3.4%, are both at twelve-year highs.
That’s the past; what about the future? The latest move in producer prices (7.3% y/y) suggests the CPI rate could peak a little higher than we expect. The NFIB survey shows a record share of small businesses are, and intend to continue, raising prices. The Beige Book finds that most businesses “expected further increases in input costs and selling prices in the coming months”. Given the giddy mood among consumers, many flush with excess savings, businesses might have more success raising prices, at least for a while. And, consumer purchasing power will get a boost from the expanded child tax credit that started this month, which, in aggregate, will more than compensate for the loss of emergency unemployment insurance payments.
Not all the stars align with higher inflation. Oil prices have levelled off pending an OPEC+ deal, and a recent upturn in U.S. oil production could keep crude prices hovering around $70 in 2022, as we expect. Lumber has been chopped down, now only double early 2020 levels instead of quadruple, leading some hardware stores to carve the price of a 2-by-4. Excluding food and energy, import prices are rising only modestly, suggesting global competition, despite the trade wars, is battered but not beaten.
But labour markets pose the greatest risk of inflation persistence. The Beige Book provided more anecdotal evidence that staff shortages are curbing production and leading to “increased use of non-wage cash incentives to attract and retain workers”. Our in-house measure of labour market slack suggests the U.S. economy may already be operating at, or even a little above, full employment.
The upshot is that inflation risks remain squarely on the high side. Chair Powell, facing heated questions in Congress this week, said the current inflation period is “unique in history”. The next few months should reveal just how special, and possibly not so transitory, this cycle really is.