Inflation: Beware of What Fed Wishes For

Excerpt from recent Morning Briefing.

Last year during August, Fed officials announced that they were aiming to overshoot their 2.0% inflation target for the PCED because they had undershot it for so long. Their wish has come true in recent months. The headline and core PCED inflation rates, on a y/y basis, rose to 2.4% and 2.0% during March and continued to move higher, to 3.9% and 3.4%, during May (Fig. 1). They likely moved even higher in June. On Wednesday, we learned that the headline and core CPI inflation rates rose to 5.4% and 4.5% last month (Fig. 2).

It’s getting harder to believe that all this inflation is just a transitory base effect phenomenon. That’s been Fed Chair Jerome Powell’s interpretation of recent inflationary pressures. In his opinion, they mostly reflect rebounds in prices that were depressed a year ago by the lockdowns and temporary supply bottlenecks resulting from a surge in demand as the economy has reopened. Consider the following:

(1) Three-month inflation rate. Over the past three months through June, the headline and core CPI annualized inflation rates are 9.3% and 10.2% (Fig. 3). Those are startling increases considering that the cost of medical care services fell at an annual rate of 0.7% over the past three months. That was more than offset by the rebounds in rent of primary residence and owners’ equivalent rent to 2.7% and 3.4% (Fig. 4).

(2) Base effect. Arguably, some CPI components are up sharply as a result of the base effect, even using the latest three-month numbers (annualized): lodging away from home (62.4), airfares (84.3), and car & truck rental (148.0). However, the price of gasoline, which peaked at 98.8% during the three months through March, was up only 1.6% through June (Fig. 5).

(3) Off base. On the other hand, the following annualized price increases over the last three months seem to be more pernicious: new vehicles (16.5%), used car & trucks (121.8), motor vehicle parts & equipment (10.0), household furniture & bedding (19.2), food (6.4), apparel (9.0), tobacco (3.6), tuition & childcare (3.0), and energy services (9.2).

(4) Expectations. By the way, on Monday, the Federal Reserve Bank of New York (FRB-NY) released its June survey of consumers’ inflationary expectations. The one-year-ahead median jumped from 4.0% during May to 4.8% last month, while the three-years-ahead median edged down to 3.6% (Fig. 6). June’s Conference Board survey found that 12-months-ahead inflation expectations rose to 6.7% (Fig. 7).

In recent remarks, Powell has claimed that inflationary expectations remain “well anchored.” In the July 7 Morning Briefing, in a story titled “Anchor Aweigh?,” we asked, “At what point do rising short-term inflationary expectations become a long-term concern?”

(5) Small business survey. On Tuesday, we learned that June’s survey of small business owners, conducted by the National Federation of Independent Business (NFIB), found that 47% of business owners are raising their average selling prices, the highest reading since January 1981, which was the tail end of the Great Inflation of the 1970s (Fig. 8).

Price hikes were most frequent in wholesale (82% higher, 4% lower), retail (63% higher, 1% lower), and manufacturing (62% higher, 5% lower). Seasonally adjusted, a net 44% of respondents plans to hike prices (up 1 point). The NFIB concludes, “The incidence of price hikes on Main Street is clearly on the rise as owners pass on rising labor and operating costs to their customers.”

(6) ECB. On July 8, the ECB announced that it would target 2% inflation in the medium term rather than “below but close to 2%.” In other words, like the Fed, the ECB will tolerate short-term overshoots to its inflation goal. The strategy change came as the ECB completed its first policy review since 2003, which began during January 2020. The ECB is joining the Fed’s faith in FAITH, i.e., flexible average inflation targeting hope.

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