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    Instant Insights: Health check

    Instant Insights: Health check

    February 10, 2022 Fixed income

    CPI accelerated yet again with headline and core both up 0.6% in January or 7.5% and 6% annualized respectively, both higher than expected.

    Importantly, the relatively “sticky” Healthcare segment was one of the sectors responsible for the rise, while less sticky Airfare and Used Car segments also had a large impact.

    Healthcare inflation poses a longer-term risk

    Healthcare prices pose a greater challenge for the Federal Reserve (Fed) if the trend continues, given its sticky nature (Table 1).

    Table 1: Healthcare costs pose a sticky threat to inflation1

      Sticky categories Flexible categories
    CPI category (month-on-month) Health services Owner's equivalent rent Education and communication Airfare Used cars Apparel
    20-Dec -0.1% 0.2% 0.1% -2.7% -1.1% 0.5%
    21-Jan 0.5% 0.1% 0.1% -1.8% -0.9% 1.4%
    21-Feb 0.4% 0.2% 0.1% -2.1% -0.7% -0.5%
    21-Mar 0.1% 0.2% 0.0% 0.9% 0.3% 0.4%
    21-Apr 0.0% 0.2% 0.2% 10.0% 9.8% 0.6%
    21-May -0.1% 0.3% 0.2% 8.8% 7.7% 1.1%
    21-Jun 0.0% 0.3% 0.1% 0.9% 10.1% 0.5%
    21-Jul 0.2% 0.3% 0.1% -3.3% 0.0% 0.1%
    21-Aug 0.2% 0.3% 0.2% -8.6% -1.2% 0.3%
    21-Sep 0.2% 0.4% 0.3% -5.9% -0.5% -0.7%
    21-Oct 0.4% 0.4% 0.2% -1.1% 2.5% 0.6%
    21-Nov 0.3% 0.4% 0.1% 1.9% 2.4% 0.7%
    21-Dec 0.3% 0.4% 0.1% 2.5% 3.3% 1.1%
    22-Jan 0.6% 0.4% 0.1% 2.3% 1.5% 1.1%

    The other major sticky category we have been watching is Rents, as measured by owners’ equivalent rent (OER), given its ~24% CPI index weight and the fact that rents are typically locked in for a year. This month it remained stable, but at a relatively high level of 0.4%.

    Turning to the messier “flexible” categories: Airfare, Apparel and Used Cars showed strong gains, but we expect them to continue to wax and wane. For example, the Manheim used car index indicates used car prices will stabilize again.

    Inflation pressures have been broadening

    Elsewhere, Services inflation (outside shelter components) at a ~61% weight has also accelerated in recent months (Figure 1), potentially as providers are anticipating wage growth. Should the current pace continue, it will be harder for CPI to revert to 3% by the end of 2022, in the absence of a reversion in Goods inflation.

    Figure 1: Goods and Services inflation makes it harder for CPI to reach 3% by year-end2


    This has not been helped by Goods inflation remaining high, with slowly decreasing supply-chain disruptions yet to feed through into durable goods prices. In our view, inflation in Goods would need to turn negative for the CPI index to realistically return to ~3% pa by the end of the year, which is possible but not a given.

    Our central case now is for CPI finish this year between 2.5% and 4%, lower than current levels but well above the Fed’s target and remain elevated well into 2023.

    CPI index weighting changes will also influence the course of inflation

    The Bureau of Labor Statistics has adjusted CPI weights to reflect spending shifts, which have been major during the pandemic.

    The weighting to “Food away from home” (i.e. dining out) fell the most, while Owners’ equivalent rent received a higher weight given the rise in first-time homebuyers, as did Autos (Figure 2).

    Figure 2: Rents and Auto inflation have larger CPI weights than before2


    The impact will likely be mixed. For example, a downward reversion in used car prices would reduce CPI more that it would have before. But on the flip side, an acceleration in shelter would have a greater impact to the upside.

    In our view, we expect CPI will be marginally higher due to these changes in H1 2022 given the rental impact and then marginally more disinflationary in H2 2022 and 2023 as supply chains heal further.

    We believe CPI will normalize but the question is when

    Several factors will determine how fast CPI can normalize from here, such as the feed-through of supply chain improvements into consumer goods, global energy prices, shelter inflation’s path and wage growth.

    Shelter inflation, and to some extent Healthcare, remain the greatest upside risks. For us, however, it is a question of “when” rather than “if” supply chains heal and normalize goods prices.

    This print provides more ammunition for the Federal Reserve (Fed) to hike in March. However, a 50bp hike in March (currently priced at roughly 50:50 by markets), still appears unlikely to us. In our view, 25bp offers the Fed greater room to maneuver, while several members have recently pushed back on the idea of moving 50bp. We expect to see three 25bp rate hikes this year after March, with the risk of five hikes.

    We also expect the Fed to begin reducing its balance sheet by June, data-permitting. However, longer-term, we believe factors such as fiscal drag will moderate consumer demand, helping to alleviate pricing pressure, and allowing for a gentler hiking cycle than the most hawkish estimates.

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