Inflation Tends To Be Spikey

The following is an excerpt from our May 2, 2022 Morning Briefing.

Why is the 10-year Treasury bond yield only around 3.00% when the latest headline CPI and PCED inflation rates were 8.5% y/y and 6.6% y/y? Why would bond investors willingly lock in such a painful negative real return? The return would be even worse if the yield were to climb to 4.00% or even higher, narrowing the gap with inflation but subjecting current bondholders to a significant capital loss.

Alternatively, the gap would narrow if inflation were to come down. Historically, inflation in the US since 1921 has been very spikey, except during the Great Inflation period from 1965 through 1980. The faster it has gone up, the faster it has come down (Fig. 13 ).

The current inflation spike has been led by soaring consumer durable goods prices, much like the inflation spike during the second half of the 1940s. Back then, household formation surged as the soldiers returned home, and so did the demand for housing and consumer durables (Fig. 14 ). Debbie and I continue to expect that durable goods price inflation will soon peak and moderate as rapidly as it jumped up over the past year (Fig. 15 ).

Now consider the following related observations:

(1) The Great Inflation. While there are several similarities between now and the Great Inflation (including bad policies and bad luck), one difference is that the dollar was very weak back then, while it is very strong now. However, both now and then, commodity prices soared. Productivity growth collapsed during the 1970s, whereas it has been rising since 2015 and should continue to do so.

(2) Consumer durable goods vs rent. The PCED’s durable goods inflation rate might have peaked during January at 11.5% y/y. It edged down to 10.2% during March (Fig. 16 ). The problem is that rent inflation is likely to continue rising over the next 12-24 months (Fig. 17 ). Tenant rent was up 4.4% y/y through March, the highest pace since May 2007. On a three-month basis at an annual rate, it was 6.2%. During the Great Inflation, tenant rent inflation on a y/y basis soared from around 1.0% during 1965 to about 10.0% during 1980.

(3) Regional price surveys. We now have April results of the regional business surveys conducted by five of the Federal Reserve System’s district banks. The averages of both the prices-received and price-paid indexes remained elevated in record-high territory (Fig. 18 ). The good news is that the average of the indexes for unfilled orders and delivery times fell in April to the lowest since December 2020, suggesting that supply-chain disruptions may be easing (Fig. 19 ).

(4) Employment Cost Index. There was a hint of a peak in Q1’s Employment Cost Index (ECI) released on Friday. The wages and salaries component of the ECI showed an increase of 5.0% y/y, the same as at the end of 2021 (Fig. 20 ). Nevertheless, that reading was the highest since Q1-1984. The overall index rose to 4.8%, boosted by a big jump in benefits from 2.9% during Q4 to 4.1% during Q1. The data suggest that employers are trying to hold onto their workers, and attract new ones, by offering better benefits on top of better pay.

The ECI data start during Q4-1979. So we get a better historical sense of wage inflation using average hourly earnings (AHE) for production and nonsupervisory workers, which starts during January 1964. The y/y percent change in the AHE series tends to be just as spikey as the core PCED inflation rate (Fig. 21 ).

The question is whether a recession is necessary for price and wage inflation to spike down. Stock investors apparently have concluded that it is. We aren’t so sure given that we still see a 30% risk of a recession and a 70% chance of a soft landing with real GDP growing slowly, say by 2.0%, and with PCED inflation peaking soon between 6.0%-7.0% and moderating to 3.0%-4.0% next year. Such a soft-landing scenario seems to be an increasingly contrary outlook.

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