After rising in January, the core PCE index, which does not include the more volatile components of food and energy, albeit slightly, is down. The indicator chosen by the FED, to monitor inflation, rose 4.6 percent year-on-year, a slight slowdown from the growth rate recorded in the previous month, revised upward to 4.7 percent.
According to the report, the largest increases were in housing and healthcare spending. Apart from increased spending in restaurants and other service activities, all other sectors showed signs of slowing down. Spending trends indicated that the narrative of a “robust and resilient” consumer is beginning to no longer hold up.
Yet there is concern that inflation will continue to show more stickiness, especially in services driven by wage growth that is likely to keep price growth above the central bank’s target for the foreseeable future.
To understand possible future scenarios, a brief analysis of the origin of this inflation cycle that the economy is facing is necessary.
The origin of the cycle
The past three years have been a very challenging period for statisticians who calculate inflation rates. In normal economic times, people’s consumption follows fairly consistent patterns, and therefore, inflation rates can be calculated relatively reliably. With the onset of the pandemic first making the purchase of goods and services unavailable and the subsequent reopenings later, complicated by global supply bottlenecks, the situation has become much more complicated and challenging. Finally, into an already precarious picture came the energy crisis as a consequence of Russia’s invasion of Ukraine, which temporarily drove energy (and food) prices to extreme levels with consumers again forced to change their consumption behavior.
Wanting to check whether or not the reading given so far is correct the well-known decomposition into core/non-core components is not sufficient as an additional approach is needed to decompose inflation into supply and demand factors. We will also always rely on the PCE index in the version stripped of the more volatile components such as energy and food. The choice is dictated by the fact that, in addition to being the measure followed by the FED, as previously mentioned, items such as rents and housing account for 18 percent versus 40 percent for the core CPI. The latter in fact could be misleading in that even small increases in rent and housing prices can in principle, have large effects on overall inflation.
Source: compiled from Bureau of Economic Analysis, Haver Analytics, Bloomberg data based on econometric model (VAR) . The graph breaks down annual changes in core PCE inflation into contributions that can be driven by demand and supply (energy price increases ect), with the rest marked as ambiguous (what the model cannot categorize)
The approach suggests how most of the high inflation in the 2021-2022 period is largely due to supply-side issues, which in fact contributed about 2.5 percent more than the pre-pandemic average, while demand-side factors were 1.4 percent higher, again than the pre-pandemic average. Only the combination of the pandemic, global freeze, massive fiscal stimulus, and surge in demand for goods initiated the inflationary growth we witnessed.
Over time, inflation has shown a downward trend due mainly to the contribution made by supply, while demand-driven inflation has remained at historically high levels corroborating concerns that core inflation may be structural in nature.
But is this really the case?
Are inflationary pressures likely to remain or can we expect the peak to have been reached?
Let us try to answer by looking at the trends in the factors that have driven inflation so far, starting with supply-side factors.
In this regard we rely on two indicators that measure supply chain pressures, one developed by the New York Fed and the other by Citigroup. Both paint the same picture with a strong improvement in global supply bottlenecks. Encouraging signs are also coming from the price front with the Bloomberg Commodity index down 8.73 percent since the beginning of the year and, from the highs reached last June, down 24.63 percent. The largest decline is in the energy component followed by metals and industrials. Only soft commodities continue to show slight “relative strength” (down 11.88% from the peak).
Source: Bloomberg, NY FED.
Source: Citi Research.
Further confirming this reading, it is useful to note that producer prices have returned toward 3.2 percent, which is the average growth rate since 1948. This index is considered a leading indicator of consumer inflation because, in most cases, when producers pay more for goods and services, they are likely to pass the higher costs on to consumers.
While this value, in an absolute sense, may not say much, what is important is that it represents the fastest pace of disinflation in history. Looking at the chart, one cannot help but see that the Federal Reserve is at a high risk of overshooting its inflation target, particularly if one inclines that the collapse in commodities and the PPI index is a guide going forward.
Source: Compilation from Bureau of Labor Statistics and Fed data.
Source: Bloomberg, Fed.
Most investors did not seem to worry too much about inflation 18 months ago when the money supply had reached an all-time high. Now inflation is in the foreground, but the money supply (M2) is negative. In fact, there is a historical correlation between money supply and inflation that usually occurs precisely eighteen months late. According to money supply theory, in fact, inflation depends on the supply and its speed. We are currently witnessing the most powerful decline since 1960, the effect of which is offset only by the growth in velocity. Although the latter is too unstable to make accurate predictions, it is difficult to think that it can continue the upward trend, considering also the fact that, compared to the magnitude of the rise that has occurred, the reversal of velocity has been contained. Should the correlation hold this time as well, the possibility of seeing new lows is not remote.
As the chart shows, on the decomposition side the greatest pressures come from demand-side factors, but even here we are beginning to see signs that something is changing.
Wages and the labor market
Sustainable, demand-driven inflation requires that wages grow in a way that can sustain higher prices. As the chart shows, wage growth is already slowing. According to the latest Labor Department report, average hourly wages rose 4.4 percent year-on-year in April, up from about 6 percent a year ago. In addition, according to a new report by the Pew Research Center, only 3 out of 10 workers are demanding a higher wage than their employer initially offered.
Source: Left: Bureau of Labor Statistics, data seasonally adjusted. Right: Bloomberg Breakeven 10 Year & Breakeven 5 Year.
This dynamic can be explained by two main factors. We know that the longer inflation and its expectations remain high, the higher and longer-lasting the pressures on wage growth will be, but both measures, market and survey-based, are declining and will over time go to fuel the opposite process. Second, a strong labor market is needed. Although the unemployment rate remains below 4 percent the number of permanent job losses has begun to rise significantly, especially in the range where wages pay best. The graph below shows how the latest increase was very high and in line with what happened in previous recessions.
The current strength has mostly been masked by the continued demand for workers to perform relatively low-level jobs. Thus the labor market, as a whole, is not as healthy as it seems at first reading, suggesting a further future decline in average hourly wages.
Source: Left: Bureau of Labor Statistics, data seasonally adjusted.
The U.S. LEI Index
In further support that the demand component is set to return one of the most popular leading indicators, the U.S. LEI index, which aggregates 10 underlying series including average weekly hours in manufacturing, initial claims for unemployment insurance, new orders for capital goods, and consumer confidence has fallen to its lowest level since November 2020, indicating worsening future economic conditions. The Conference Board itself predicts that: “economic weakness will further intensify and spread more widely in the U.S. economy in the coming months, leading to a recession beginning in the second half of 2023.”
Source: The Conference Board.
The housing market
Finally, the housing market, which has fueled economic activity, and inflation growth is also cooling. Indeed, historically, house price growth (expressed as a 12-month growth rate) has preceded rent inflation and OER (owner-equivalent rent) inflation by just under two years. Thus, it is shown how house price growth has historically been useful in predicting rental and OER inflation rates given the high correlation.
Given the recent slowdown, with the median sales price of existing homes down 0.95 percent year-over-year, it is not illusory to predict a future decline in these housing components that will be reflected in overall inflation.
Source: National Association of Realtors (NAR), Bloomberg.
To recap, supply shocks have had particularly large effects during the period of rising inflation by contributing more than the demand component, despite the latter being at its peak, to overall inflation. Overall, supply shocks have often been the cause of large swings in inflation. In contrast, negative demand shocks tend to exert downward pressure during recessions. The latter were particularly substantial during the Great Recession.
Unless further (positive) demand or supply shocks or a combination of both occur, as was the case after the pandemic where inflation was fueled by a combination of supply shocks, caused by supply chain shutdowns, and pent-up demand amplified by fiscal stimulus cycles, the inflation problem is likely to return to the levels of past years, presenting a transitory nature. Therefore, we do not believe that the current period is a repeat of the 1970s, especially in light of what is happening to the banking sector.
In our view, by the end of 2023, recession, slowing wage growth, falling real estate prices, and falling inflation are the most likely scenario.