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    Instant Insights: Wall of cash meets wall of worry

    Instant Insights: Wall of cash meets wall of worry

    September 23, 2021 Fixed income

    Today’s CPI report was a sign that we are indeed passing peak inflation, a first step towards fulfilling our (and the Fed’s) base case that inflation will prove transitory.

    Mission: On track

    However, as we have also argued, this does not mean a return to 2% CPI is imminent. With headline CPI at 5.3% and core at 4%, the descent will take time. In our view, headline CPI will likely end 2021 at ~4% and stay above 3% until mid-2022, before declining further into the end of 2022. For the Fed, this report amounts to ‘Mission: on track’ rather than ‘Mission: accomplished’.

    Trends point to deceleration

    Inflation momentum appears to be fading. Since Q2, month-on-month price rises have decelerated in both core and headline CPI. This month’s figures (0.3% and 0.1% for core and headline respectively) are quite similar to the pre-COVID norm (Figure 1).

    Figure 1: Monthly momentum in CPI figures is slowing1

    It makes the Q2 CPI prints look increasingly anomalous, rather than the start of a new trend. Due to base effects, however, they will continue to influence every year-on-year CPI print until mid-2022.

    Flexible inflation drivers finally appear to be reversing

    Specific sectors, where prices were sensitive to developments relative to the pandemic were generating unsustainable gains in Q2. However, the tide may finally be turning.

    There are five key sectors we are following where prices are still ~20% higher than they were a year ago, collectively fell 1.3% in August (Table 1).

    Table 1: ‘Flexible’ CPI categories are potentially reversing2

     CPI index weightYear-on-yearMonth-on-month
    Used cards 3.5% 31.9% -1.5%
    New cars 3.8% 7.6% 1.2%
    Airfare 0.2% 6.7% -9.1%
    Hotels 1.0% 19.6% -3.3%
    Rental cars 0.7% 52.6% -8.5%
    COVID-sensitive sectors total 9.2% 21.6% -1.3%

    Looking ahead, new cars in particular may still see pricing pressures given ongoing supply chain issues, but these sectors will likely contribute less and less to inflation in coming months.

    Meanwhile, the large ‘sticky’ categories that we follow like owners’ equivalent rent and health care have continued to show muted inflation pressures (Table 2).

    Figure 3: ‘Sticky’ categories remain muted3

     CPI index weightYear-on-yearMonth-on-month
    Owner's Equivalent Rent 22.4% 2.5% 0.3%
    Medical Commodities 1.5% -2.5% -0.2%
    Medical Services 7.1% 1.0% 0.3%
    Education and Communication 6.1% 1.3% 0.2%
    Sticky sectors total 37.0% 1.8% 0.3%

    We still see little evidence that these sticky categories will meaningfully accelerate over the next 12 months, albeit we will not rule out the possibility. And even then, we expect the normalization in the ‘COVID-sensitive’ sectors would overpower it.

    There will be bumps in the road

    Supply chains remain fragile, and inflation figures will remain above 2% for some time. But our core thesis holds that above-target inflation cannot sustain indefinitely unless it is driven by large, sticky categories. Today may be a turning point, and as COVID-sensitive inflation dampens, overall inflation should gradually fall towards target.

    Today’s report will likely increase the market’s confidence that the Fed is correct to forecast transitory inflation. As such, we would view a tapering announcement at next week’s FOMC meeting as extremely unlikely. We see November as the first ‘live’ meeting, assuming there is a strong September jobs report.

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