The Inflation Cold Front

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After weeks of steamy hot temperatures, a cold front is set to move through the Boston suburbs on Tuesday. While the relief will be nice, in truth, the temperature will only edge down from the low 90s to the low 80s. However, it is the start of something and, as we are well aware in this part of the country, longer-term forces will bring us much colder weather before too long.

A similar paragraph could be written about inflation. The consumer price index climbed 1.0% in May and 1.3% in June, pushing the year-over-year inflation rate to 9.0% - its hottest pace since November of 1981. Sharp declines in gasoline prices and airfares should cut the monthly inflation rate to just 0.2% in July and it could even turn negative in August. Thereafter, declines in inflation may be slower due to some stickier elements of the inflation picture. 

However, a longer-term view suggests that both less demand and more supply will erode inflation in the years ahead, returning the U.S. economy to a financial landscape much like that which preceded the pandemic. A key question for investors is whether the Federal Reserve will be satisfied with this inflation easing timetable or, by trying to accelerate it, they tip the economy into recession.

Short-Term Inflation Relief

One challenge in forecasting inflation lies in the sheer breadth of the goods and services that consumers buy. The Bureau of Labor Statistics collects prices for approximately 80,000 goods and services every month across 75 urban areas and 23,000 retail establishments. However, certain prices are more important than others in determining swings in overall inflation. 

In particular, between them, gasoline prices and airline fares accounted for 0.2% of the 1.0% increase in CPI in May and 0.4% of the 1.3% CPI increase in June. Based on high-frequency data we expect these two categories to subtract 0.3% from the July headline CPI and 0.5% from the August reading. Falling food commodity prices, a small decline in wholesale used car prices and purchasing manager reports showing slower growth in prices paid, suggest that July’s CPI inflation rate will be close to 0.2% overall and 0.4% excluding food and energy. At this stage we estimate even softer August readings of -0.1% overall and 0.3% excluding food and energy. 

Stickier Inflation Components.

However, even as food and energy inflation moderates, there are clearly some elements of the broader inflation surge that will stick around for a while. 

First, wage growth remains strong with last Friday’s July jobs report showing monthly wage gains of 0.5% for all private-sector workers. While year-over-year wage gains have now declined from a peak of 5.6% in March to 5.2% in June, this remains very elevated relative to pre-pandemic levels and continues to pressure companies to increase the prices they charge to consumers. Moreover, while job openings have now fallen by 1.2 million over the past three months, they remain very high by historical standards suggesting continued cost pressure from a tight labor market.

Second, inflation expectations remain above pre-pandemic levels although they have moderated in recent weeks. On Friday, the gap between the yield on 10-year nominal Treasuries and 10-year TIPS was 2.48%, implying that Treasury investors expect CPI inflation of 2.48% over the next decade. While this has fallen from a peak of 3.02% in early April, it is still above the average inflation expectation of 2.13% in the 20 years before the pandemic. Consumer expectations of inflation over the next five years fell from 3.1% in June to 2.9% in July according to the University of Michigan sentiment survey but also remain above pre-pandemic levels. These higher inflation expectations could help keep inflation elevated by encouraging workers to demand higher wages and businesses to raise prices.

Third, low rental vacancy rates, huge recent increases in home prices and, more recently, much higher mortgage rates have all pushed rental rates higher. Importantly, while actual rent paid has a 7.4% weight in the CPI, owner’s equivalent rent, (which is the rent homeowners would pay if they rented rather than owned their homes), accounts for 24.3% of the index. Both of these series will likely show strong increases for some time to come, bolstering core inflation.

Drags on Demand as Supply Recovers

These stickier factors should slow the decline in inflation and we generally agree with the Fed’s view that year-over-year inflation, as measured by the personal consumption deflator, will fall from 6.8% in June to 5.2% in the fourth quarter of this year and somewhere between 2.0% and 3.0% by the fourth quarter of next year.

However, we would argue that achieving a consistent decline in inflation is probably more important that the pace of that decline. And there continue to be gathering forces on both the demand and supply sides that are likely to cut inflation further.  

First, there is fiscal drag. Prior to the recent flurry of legislation, it appeared that the federal budget deficit would fall from $2.8 trillion, or 12.4% of GDP, in fiscal 2021 to roughly $790 billion, or 3.2% of GDP in fiscal 2022, which ends in seven weeks, and $740 billion, or 2.9% of GDP in fiscal 2023. Nor does recent legislation change this trend. According the Congressional Budget Office, the Inflation Reduction Act which looks set to pass Congress this week and the CHIPS Act, which was passed in late July, would lead to further small reductions in the deficit in fiscal 2022 and 2023. While this reduces the risk of any fiscal crisis, it does amount to very severe fiscal drag that is squeezing household income and should drag on consumer spending going forward.

Second, there is the dollar, which has climbed 15% over the past year. The combination of a strong dollar and a slowdown in global growth, that was very evident in last week’s PMI releases, should slow U.S. exports and increase imports, placing a further drag on the economy.

Third, there is construction. U.S. single-family building permits have now fallen for four consecutive months and could fall further in the second half of the year as soaring home prices over the pandemic and suddenly much higher mortgage rates box many first-time homebuyers out of the market. Meanwhile, much lower growth in corporate profits will likely constrain capital spending while inventory rebuilding will have to slow from its clearly above-trend $82 billion annualized pace in the second quarter.

Even as these factors are restraining demand, supply is improving. The vendor delivery index is well off its peaks for both manufacturing and services while inventories are being rebuilt across the economy. Strong increases in the number of truck drivers, auto manufacturing workers and oil industry workers suggest some success in rebuilding supply in the tightest bottlenecks in the U.S. economy. 

Overall, with demand slowing and supply picking up, we expect to see steady downward pressure on inflation for the rest of this year and in 2023 even if the Federal Reserve pursues a slightly less hawkish path.

Depending on the Data 

The Fed has vowed to be data dependent and last Friday’s booming U.S. jobs report has given more ammunition to the hawks. However, it seems likely, based on high frequency data, that the August employment numbers will be less impressive than the July results, while the economy should see a significant moderation in headline inflation. If this is the case, and particularly if the Federal Reserve takes proper heed of the forces applying the brakes to the U.S. economy, we still expect them to raise rates by just 0.5% in September in one of the last increases in this sharp but short tightening cycle. Such a moderation in the Fed’s messaging and actions would be positive for U.S. stocks and bonds and for returns on international equities as the dollar slips reflecting a U.S. economy set to experience cooler inflation, slower growth and lower-than-expected peak interest rates.

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