Inflation: To Be or Not To Be

Where will inflation be in 2023? That is the one million dollar question. It's what is driving Jerome Powell to raise rates higher for longer. It's what is driving mortgage rates to recent highs, hitting the breaks on the housing market and sending treasuries to recent highs, while tanking risk assets.

One school of thought on the question is that we've seen the worst, and we're heading back down to more normal levels over the next 12-18 months. You can point to headline CPI, which has dropped....a little.

Or look to energy prices or copper, which can be seen as an indicator of the overall economy. Pricing on shipping containers is back to pre-covid levels, as is lumber. It's true, much of the so-called inflation that we saw the past year was supply chain-related. So if supply chains work themselves out, that should cool things off.

One indicator that shows market expectations on inflation is the 5yr5yr forward rate, which shows were the market expects rates to be on average over the next 5 years. And this paints a rosier picture.

That's a 2.39% rate down the road, down from 4.29% today. So inflation, not going to be a problem, we're all good, right?

I'll give 3 counterarguments, reasons why inflation will be around for years. It might cool off a little, but likely above 6%, according to this line of thinking.

1) Energy is a key component of consumer prices. Think about it, energy is underlying the price of everything--goods on the shelf, cost of delivering you're Amazon package, the cost to produce the Amazon package as well as everything else we consume, not to mention heat our homes and keep on the lights.

The oil and rig count in the US is sitting around 750, far below the average of 2005-2014, which was closer to 1700. The megawatthours (MWh) from nuclear power peaked in 2002, and has remained level since then. And a full 80% of US energy comes from fossil fuels and nuclear (per the EIA as of November 2022). To think that renewables, however promising, are ready to ride in and save the day is choosing to ignore reality.

To the extent we shut down fossil fuel sources, and refuse to build nuclear, we are choosing to pay more for everything. This ensures that prices will remain higher for longer.

2) Per Bob Elliott (@BobEUnlimited), core inflation doesn't fall until 12-18 months of slowing private sector compensation growth. In 2022, private compensation has grown 7%. Looking back at other periods (2000-2003, 1988-1992) this relationship has held up. So at least 12-18 more months of elevated inflation, even if wages start to fall now, would be expected.

3) Per Patrick Saner at Credit Suisse (@patrick_saner), "Data since 1920 shows that once CPI > 8%, it takes around 2 years (!!!) to even fall beneath 6%. Yet, current consensus expects us to be back at or even below 3% in just 2 years."

Where will inflation be in 2023? I have no idea really. But I can think of some good reasons we could see it stick around for a while.