Why Inflation still looks mostly Transitory

Financial market commentary in the week ahead will likely center around the question of inflation.? The headlines speak for themselves.? CPI inflation jumped to 6.2% year-over-year in October, its highest reading in 31 years.?

In a world where short political soundbites often drown out rational economic analysis, the reasons for this surge are usually over-simplified, with commentators focusing on just one of many factors ranging across pandemic-related supply-chain disruptions, over-easy monetary policy, excessive fiscal stimulus, over-regulation, not enough workers, hardline OPEC producers and corporations exerting near-monopoly power.

However, while many of these issues have contributed to the inflation surge, the best way to understand it and to predict where inflation goes from here is to examine the major contributors to the inflation surge on a sector-by-sector basis.? This exercise suggests that most of the current inflation pressures are indeed transitory and should ease in the year ahead.

Energy

The October CPI report showed broadly rising inflation.? However, there were some particular areas which made an outsized contribution to the 6.2% gain.? The most obvious of these was energy, where a 30% increase over the past year contributed 2.2 percentage points of the overall 6.2% rise.

This is largely due to strong gains in oil prices, with West Texas Intermediate Crude more than doubling over the past year from $39.40 per barrel in October 2020 to $81.48 in October 2021.? This, in turn, reflects a faster rebound in global oil demand than supply.? The OPEC+ group is, so far, being quite disciplined in only slowly ramping up production.? However, at over $80 a barrel, U.S. shale oil should be very profitable and we expect to see U.S. and non-OPEC production in general, increase sharply in the year ahead.?

A similar story can be told surrounding natural gas prices, where Henry Hub spot prices also more than doubled to $5.51 per million BTU in October 2021 from $2.39 a year earlier.? Again, high prices should encourage more supply.

The important implication of this is that, based on forecasts from the Energy Information Agency, we expect that energy prices will fall by 7.0% over the next year, subtracting 0.5% from CPI.? If every other number in the October 2022 CPI was the same as in the 2021 report, the swing in energy prices alone would cut inflation from 6.2% year over year to 3.5%.

Vehicles

The motor vehicle sector is another important area of higher inflation recently that may actually reduce inflation in the year ahead.? In October, new vehicle prices were up 9.8% year-over-year and used vehicle prices were up 26.4% year-over-year.

This clearly reflects a lack of inventory, with vehicles on dealer lots plummeting to under 40 days of sales by the end of September, compared to an average of 64 days of sales over the past decade.? The lack of inventory is widely reported to be due to the global shortage of computer chips which helped cut U.S. auto production by 13.7% year-over-year in September.

However, automakers will likely find ways of increasing production in the months ahead.? One positive sign was a 3.0% month-over-month increase in auto manufacturing employment in October and analysts expect a strong gain in motor vehicle output in the October industrial production release, due out on Tuesday.? If vehicle production is able to outpace demand and lead to a recovery in inventories in the year ahead, then new vehicle prices should rise much more slowly and used car prices should decline.? Over the next year, a 2% rise in new vehicle prices and a 5% decline in used vehicle prices would turn a 1.2 percentage point addition to year-over-year CPI inflation over the past year into a 0.1 percentage point subtraction.

Food

Food prices have also been rising quickly over the past year with prices at grocery stores rising by 5.4% and restaurant prices climbing 5.3%.? Combined, these price increases contributed 0.7 percentage points of the 6.2% year-over-year increase October CPI.?

Part of this story is undoubtedly supply chain disruptions.? The ISM vendor delivery index, which measures the number of purchasing managers reporting slower rather than faster deliveries, hit an almost 50-year high in May and has remained at close to this extreme since.? Another problem is clearly labor shortages where there are now a record 3 million more job openings than people unemployed in the U.S. economy.

However, it must also be noted that real consumer spending on food has increased at an astonishing rate, with total real spending on food at home rising by 12.9% between September 2019 and September 2021 and total real spending on restaurant meals rising by 2.5% over the same period in which the Census Bureau estimates the population grew by just 0.8%.?

While hoarding in the early days of the pandemic undoubtedly contributed to a surge in food spending early on, it is likely that government aid has had a significant impact since then.? The uncomfortable reality is that food spending is most immediate area where families cut back when budgets are squeezed, particularly among lower and middle-income households.? Government stimulus checks, enhanced unemployment benefits, eviction moratoria and child tax credits likely all served a role in boosting food spending and allowing many families to switch from cheaper food to more expensive items.?

Looking forward as the pandemic eases, the supply side disruptions will likely diminish.? Moreover, even if, as we expect, a reconciliation bill is finally passed by Congress extending the child tax credit and enhancements to the earning income tax credit, most government aid has now lapsed and many lower and middle-income households will face more constrained finances in the year ahead, softening the demand for food. ? We estimate that food prices could rise by 2.7% in the year ahead, roughly half the pace seen in the last year and this could knock another 0.3 percentage points off the year-over-year gain in consumer prices.

Shelter

One area where inflation is unlikely to abate in the year ahead is in shelter costs.? Shelter accounts for almost a third of the consumer price index.? While it includes hotels and home and apartment rents, the biggest part, accounting for almost a quarter of the overall CPI, is a concept called “owners’ equivalent rent”, which is the rent homeowners would have to pay if they rented rather than owned their home.?

This is not the forum for an extensive discussion of the weirdness of this particular concept.? Suffice to say that it is a relatively smooth series which, for the most part, tracks actual rents paid in the economy.? However, rents and hotel rates have been rising rapidly recently and, as a consequence, the shelter component of overall CPI rose 3.5% year-over-year in October, contributing 1.1 percentage points to the 6.2% year-over-year gain.

Shelter inflation is likely to be sticky in the year ahead.? Home prices have soared over the past two years with the median prices of new and existing homes climbing by 30% and 29% respectively in the two years ending in September 2021.? Even with very low mortgage rates, landlords will want compensation for these higher prices which should put upward pressure on rents.? This could partly be offset by the reality that home-building has remained relatively strong throughout the pandemic even as population growth has slowed reflecting lower immigration.? Even with this, however, we estimate that shelter costs could climb by more than 4% in the year ahead, adding 0.2% to inflation relative to October 2021.

Other Areas of Consumer Inflation

Other areas of consumer spending should see mixed inflation pressures in the year ahead.? Airline fares will likely rise sharply but spending on flights only accounts for 0.6% of the CPI basket so this should have a limited impact on overall inflation pressures.? Labor shortages will likely lead to a continued rise in the cost of a wide variety of services.? Conversely, an easing of supply chain problems and recent overspending on consumer durable goods should cause many goods prices to ease. However, perhaps most importantly, a recent increase in inflation expectations could become embedded, allowing inflation to run a little hotter than it did in the long economic expansion of the last decade.

As inflation has risen in recent months, policy-makers and commentators who have described inflation pressures as “transitory” have been treated with increasing derision.? However, looking at the details of the inflation that we have seen and the forces that have caused it suggest that the “transitory” argument is largely correct.? While CPI inflation is over 6% year-over-year today, by the fourth quarter of 2022, we expect it to be running at a much more modest 2.3% year-over-year.

This is not to argue that the super-easy monetary and fiscal policies of the pandemic should be maintained as the pandemic winds down.? While easy policies were in order at the height of the emergency, keeping them in place as the economy moves to full recovery would only increase distortions in the economy and capital markets, reducing long-term economic growth and increasing the risk of financial shocks.

However, it does suggest that investors should keep a balanced view with regard to inflation.? This means focusing more on the potential impact of higher interest rates on portfolios and looking more carefully at valuations.?

For many investors, the real danger from inflation isn’t that their portfolios are badly positioned to handle runaway inflation – it is that capital markets are priced as if inflation was close to zero, which is not the case today and, despite a potential easing of pressures in the year ahead, will not be the case in the years to come.?

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