The inflation debate rages on
With inflation concerns heating up, today’s CPI report added gasoline to the fire.
Inflation was expected to be high today due to ‘base effects’, as the 4.2% inflation print is being measured against April 2020, when the US faced its most severe lockdowns. But it was still substantially larger than the 3.6% expectation. By coincidence, the print also occurred at a time in which gas shortages are in the news, which will no doubt prompt comparisons with the 1970s stagflation crisis.
However, looking under the hood, we believe concerns about persistent and lasting inflation are unjustified.
Used cars, recreation and travel drive the CPI beat
Much of today's beat was due to a surge in used car prices, which increased by 10% in April alone, and 21% over the last year. This alone contributed 0.3 percentage points (pp) to CPI.
There are unique factors impacting used cars, including limited new car supply, rental car companies retaining their fleet ahead of the summer travel season, and a lack of repossessions given strong consumer credit quality. Eventually, we expect these bottlenecks will pass.
Elsewhere, hotel prices were up over 7% in April, contributing about 0.1pp to headline CPI. Given the rapid pace of vaccinations ahead of the summer, it is no surprise to see a rebound in demand for recreation and travel, particularly as consumers accumulated $2.3trn in excess savings over the last year1. We expect this demand to continue rising at least through the summer, which should support a continued rise in pricing, but not at levels where it will continue to have such a lasting, outsized impact.
Signs of persistent inflation are still absent
Two of the areas that we are watching closely for signs of persistent inflation are the 'home shelter' and 'healthcare' components of CPI, which together account for about 40% of the index. A structural overshoot in inflation is unlikely unless it is felt in these areas.
However, the home shelter component was only up 0.2%, which is in line with its recent trend, and medical prices were essentially unchanged.
Prices have only just rebounded to their pre-COVID trend
The CPI index essentially just recovered to its pre-COVID trend levels (Figure 1). In other words, we have only just reversed the disinflationary effect of the pandemic.
Figure 1: We have only just eradicated the disinflationary impulse of COVID-192
This burst of inflation is likely to be transitory – but how long is transitory?
Current trends indicate high inflation prints could continue into 2022 (Figure 2).
Figure 2: Transitory inflation could still mean higher inflation prints for several months yet3
We expect base effects and lingering supply chain issues will mean that CPI could peak as early as next month, potentially above 4.5%, before moderating from there. It could, however, take until March 2022 to complete a full ‘lap’ to below 3% as supply chains are repaired, non-repeating effects of fiscal spending (such as the stimulus check payments) dissipate and inventories rebuild.
Secular disinflationary forces are still in play
We remain unconvinced that COVID-19 has structurally shifted the economy in a way that would spur a new regime of persistent and lasting high inflation. If anything, it has largely expedited secular disinflationary factors such as demographics and technological change (see our piece The Inflation Debate is Overheating for more), albeit a partial offset may be less global trade than pre-pandemic.
Like Jack Lemmon and Tony Curtis’ time in a ladies’ orchestra during the film "Some Like it Hot", we expect this bout of inflation to be at times sizzling, but transitory in the end.
The Fed has repeatedly stated that it would be prepared to look through transitory inflation without acting. This leaves several months in which high inflation prints could spark periods of market volatility as markets potentially overreact.
We believe this could provide fixed income investors potential opportunities to turn such volatility to their advantage by ‘buying the dips’.