November 11, 2022 | 12:53
Inflation: Is the Worst Behind US?
Inflation: Is the Worst Behind US?
Michael Gregory, Sal Guatieri and Aaron Goertzen
For a welcome change, U.S. consumer prices rose less than expected in October, sparking a relief rally in financial markets. The report reinforced a view that inflation has peaked, thanks to softer goods prices. Still, we see a slow decline amid sticky services prices and potentially stubborn pressure from food and energy costs.
Food For Thought
The food component of the CPI increased 10.9% y/y in October, only slightly off its peak of 11.4% in August. The good news is that there are reasons to expect at least modest further relief. Wheat prices, which surged to an all-time high after Russia invaded Ukraine, have come back into the stratosphere, in part because Russia has been allowing grain to move through ports on the Black Sea. As a result, the grain and oilseed price index published by the U.S. Department of Agriculture shed 7% between June and September, and while it is still up more than 20% y/y, the base effects will become friendlier in the coming months. Unfortunately, food inflation is being driven by far more than just grain prices. Dry conditions have plagued the West Coast for almost three years and helped launch fruit and vegetable prices to record highs, with no relief in sight. In the livestock space, the arid weather has kept the headcount of the cattle herd in decline, while avian flu has disrupted poultry production. Non-agricultural input costs like wages are also rising quickly. It’s not uncommon for agricultural prices to jump 15%-to-20% in a year, but broader consumer food inflation hasn’t seen double-digit territory since the early 1980s, which speaks to the breadth of today’s cost pressure.
Although peak food inflation may have passed, it is unlikely to lead consumer prices lower. For one thing, the shorter-term measures of food inflation, while moving in the right direction, are still running hot. And inflation for food away from home, which accounts for almost 40% of the total food basket, is still accelerating. It hit 8.6% y/y in October and is unlikely to reverse course until revenge spending and wage growth cool. The drought has also continued to intensify. Dry conditions on the plains have already left more than one-third of the winter wheat crop, which will be harvested next summer, in poor or very poor condition. And the Midwest, which until recently had been spared the weather searing the rest of the country, is beginning to dry out as well (Chart 1). Fortunately, most of this year’s corn and soybean crop has already been harvested; but if dry conditions persist into next year, they could spur a fresh leg up in food inflation. As always, the weather is the wildcard.
CPI energy prices rose 1.8% in October after falling for three straight months, but the annual change still fell modestly to 17.6% y/y owing to a favorable year-ago comparison. The pattern of the past four months mirrored the move in gasoline prices. They dropped after averaging a record-high $5.03/gallon in June, which also happened to be when headline CPI inflation peaked and WTI crude oil prices averaged a 14-year high of $114.8 per barrel (and natural gas prices were posting comparable extremes). Rising oil and gasoline prices in October reflected the output cutbacks announced by OPEC+, and contributed to a 4.4% m/m increase in energy goods prices (all fuels). However, this gain was partly offset by a 1.2% drop in energy services prices (electricity and piped gas), reflecting a more than 28% drop in natural gas prices due to elevated storage volumes and mild weather. Looking ahead, with OPEC+ resisting lower oil prices, alongside uncertainty surrounding the plan to cap Russian oil prices and the vagaries of winter temperatures, energy prices could still get re-energized. We see WTI crude prices averaging $90 a barrel in 2023, with upside risk.
Good News on Goods Prices
Excluding food and energy, CPI goods prices dropped 0.4% in October after a flat September. Over the past four months, three readings have come in at 0.2% or less for an overall annualized 1.0% pace. This helped reduce the annual change to 5.1% y/y, compared to February’s peak of 12.3%, with the prospect it could be in the 2% range within a few months if the shorter-term trend is a guide.
The peak in core goods inflation earlier this year marked a record (64-year) high apart from a couple of months in early 1975 (which was the legacy of OPEC’s oil embargo). The acceleration to such an extreme from sub-2% prints as recently as March 2021 reflected the incendiary mix of constrained supply (of goods) and strong demand (for goods). The former was primarily caused by the pandemic but also by the Ukraine war. The latter was prodded by pent-up spending and massive policy stimulus. We have long argued that if demand had not been so strong, supply would have caught up faster and the surge in inflation would have indeed proved to be largely transitory.
After an initial jump in the demand for goods to well above pre-pandemic levels, goods demand has been moving more sideways than up (Chart 2). This reflects the combination of a shift in spending toward services, delays caused by product shortages, waning pent-up demand, and, since March, the Fed’s efforts to cool the economy via tighter policy. Meanwhile, supply continues to catch up. The New York Fed’s Global Supply Chain Pressure Index recently hit a 22-month low (Chart 3), implying a closer balance between goods demand and supply, along with ebbing inflation risk.
The October CPI report showed that services prices continue to boil, albeit at a slightly lower temperature. Excluding a 16% y/y surge in the combined cost of electricity and piped gas, core services prices rose 6.7% y/y, the most since 1982. The shorter-term trends are running even faster (above 7%), suggesting stickiness. Equally concerning is the breadth of the gains, with personal and medical care services running more than 5% y/y; shelter, household operations, and admissions for cinemas and concerts clocking in at more than 6%; restaurant meals costing nearly 9% more than a year ago (the most since 1981); and auto insurance, auto repairs, and pet services posting double-digit yearly increases. College tuition is one of the few services still moving at a pedestrian 2% rate, consistent with the Fed’s target.
Four factors are driving the surge in services inflation. In the order of their expected ebbing, from sooner to later, they are:
1. Revenge travel demand: Despite earlier rapid price increases, travel demand remains robust, though it could be the first expense to get chopped in a downturn. In fact, tourism-related prices are already cooling. Hotel room charges have slowed to a 6.4% y/y pace after holding above 20% last winter. While airfares are still up 43% amid high fuel costs, pilot shortages, and delayed plane deliveries, they appear to be steadying. After accelerating through much of the pandemic, auto rentals are one of the few services to see lower prices than a year ago.
2. Rent: The CPI basket contains two rent measures that account for a combined 55% of ex-energy services costs and 40% of core inflation. Their acceleration explains why shelter costs are rising at the fastest pace since 1982 (6.9% y/y). The good news is that one of the two components, tenants’ rent (7.5%), could begin to simmer down soon due to lower apartment rents. The bad news is that the much larger component, owners’ equivalent rent (6.9%), will likely see robust gains into next year given the typical long lag (of more than a year) between it and house prices, which only recently started falling (Chart 4).
3. Household excess savings: Though down from a peak of $2.4 trillion last fall, excess savings during the pandemic are still estimated at roughly $1.9 trillion, or 10% of disposable income. That should suffice to support spending for another year, even if high inflation rapidly drains this piggy bank. That’s a key reason why we anticipate just a mild recession next year.
4. Wages: Compensation is a key driver of inflation in the labour-intensive services sector. It’s no coincidence that both unit labour costs and services inflation are running north of 6% y/y (Chart 5). The former will need to slow to around 2% for inflation to return to the Fed’s target. While average hourly earnings have eased a bit, more reliable measures of labour compensation that control for shifts in employment have yet to cool. Labour markets remain drum-tight, and unless the unemployment rate rises materially and job vacancies fall sharply, wage growth will likely stay heated. The situation is made worse by an aging workforce and worker absences related to COVID.
Bottom Line: The good news is that goods demand and prices are cooling. The bad news is that the services dial remains on high simmer, and the risks to energy and food costs are both to the upside. That’s why we remain well above consensus in calling for CPI inflation to fall only slowly and to still hover in the high 3% range in late 2023. That doesn’t mean a forward-looking Fed will need to keep hiking rates through next year, but it should dissuade easier policy until 2024.