Today’s CPI report was another upside surprise, with headline at 6.2% and core of 4.6%, both at their highest levels since the early nineties.
Over the last few months, inflation forecasting has increasingly resembled an ugly game of whack-a-mole. Just as one potentially ‘transitory’ inflation driver peaks, another pops up.
Beneath the eye-catching headlines, the real thing to watch is not the +6% print, but the modest but steady rising in ‘sticky’ inflation categories.
Energy prices drive latest inflation beat
Energy prices rose 4.8%, largely driven by natural gas and oil shortages in Europe, which is pushing up global demand.
There is light at the end of the tunnel, however. Futures curves are currently pricing in falling energy prices over the next six months on expectations that production will rise, although of course this remains to be seen.
Supply chain issues may be peaking
Supply chain issues are now showing some signs of easing in some of the most impacted consumer sectors. For example, appliance prices fell 0.1%, and furniture prices rose only a modest 0.3%.
Not all disruptions have been resolved, however. The flooding in the Northeast caused by Hurricane Ida recently created fresh demand for replacement goods, disrupting the price declines in sectors such as used cars, which notably rose by 2.5%.
Better news is that wider chip shortage issues are starting to improve, according to recent communications from auto manufacturers such as GM, Ford, and Toyota1, which all stated plans to increase production this quarter.
The ‘sticky’ inflation are showing a steady, but modest rise, watch them carefully
We urge investors to look beyond the supply chain headlines and focus on ‘sticky’ sectors like rents (see Instant Insights: Stubborn but Stabilizing).
Steady rises in these categories do the most to jeopardize the Fed’s projected ‘transitory’ inflation trajectory than the supply chain issues that dominate the headlines.
Over time, rents have proven to be the best indicator of inflation in our view, explaining two-thirds of the movements in core CPI, while generally printing at a rate ~1% faster) (Figure 1).
Figure 1: Rents are the inflation category to watch for clues on inflation trends2
Rents and owners’ equivalent rents both rose 0.4% in October, or 2.7% and 3.1% respectively year-on-year. In our view, if rents were to accelerate to 4% for a sustained period, that would be a clear warning sign that the Fed faces a more serious inflation problem.
Conversely, if rents settle in the low 3% zone (as it did pre-COVID), the Fed is unlikely to be worried in our view.
Another sticky sector, healthcare inflation, also rose 0.5% ( but a modest 1.7% year-on-year) as insurance premiums jumped 2%. Given relative strong insurer profits, we believe there is a risk this component stays relatively ‘hot’ over the next year.
Is ‘transitory’ inflation still a reasonable base case?
Ultimately, the jury is still out on the ‘transitory’ versus ‘persistent’ debate, but ‘transitory’, for now, remains our base case.
We believe there will be notable moderating forces in the coming 18 months. For example, rising housing starts and a large backlog of completed homes will potentially help easing rental market conditions.
However, inflation above 6% will be a worry for consumers
During the 1970s' stagflation crisis (see Credit has little to fear from inflation for more on that period), a new measure called ‘the Misery Index’ was created. It sums the unemployment rate and the inflation rate, to essentially create a measure of stagflation.
In our view, the measure helps to explain recent weakness in consumer sentiment (Figure 2).
Figure 2: Inflation is weighing on consumer sentiment3
While well-below its 1970s' peak, the Misery index is currently near its 2009 and 1990 levels – both recessionary periods. Although there is no recession today, and unemployment is relatively low, inflation is impacting the national psyche.
The challenge the Fed faces is restoring full employment while ensuring prices do not permanently de-anchor.
There may be a feedback effect that plays into the Fed’s hands, however. As unemployment continues to fall (as the labor market continues its recovery and individuals return to the labor force), the rising supply of workers will potentially temper wage growth, while potentially expanding aggregate supply. This could help alleviate both supply bottlenecks and pricing pressures.
High headline inflation figures will also naturally worry investors
Many investors will view a 6%+ inflation print as a clear signal for the Fed to switch gears.
However, in our view, last week’s taper announcement makes it unlikely that the Fed will hike until the taper is complete, and this is not currently scheduled until June (see Insight Insights: Taper time).
We believe this gives the Fed’s dovish wing greater capacity to look through near-term inflation, despite it being particularly elevated. Adding justification to inaction is that the fact Fed cannot solve near-term supply chain issues by raising rates.
Base effects make it highly likely that CPI will slow next year
Presuming supply chain issues do begin to ease, inflation will in our view, almost assuredly as tapering ends. This is simply a question of math. CPI is calculated with respect to prices a year earlier. As such, if prices fail to rise proportionately again, CPI figures will slow (all else being equal).
This is all the more reason why today’s changes in rental prices and other ‘sticky’ categories matter more for the future. These categories will also be top of mind for policymakers, and, in our view, will determine the timing of a ‘lift-off’ in interest rates as well as the pace of rate hikes.