Last week markets were jolted by an unexpected increase in US consumer prices. Suddenly, all the talk is about inflation spikes, expectations for the next few months, whether the Fed is behind the curve, and so on. Just a month ago, I spoke about tame price increases as a sign of sustained growth. Was that preliminary – are we really in for an inflation shocker?
Are we in for an inflation spike?
Let’s look at the numbers. The January increase in the US Consumer Price Index (CPI) was 0.31 per cent. While that may not look like much, if it continued for a year at that pace we’d be talking about 3.8 per cent growth. That’s a problem; it’s a lot higher than the Fed’s target range. Then consider that for the past seven months, growth has averaged an annual pace of 3.6 per cent. Are the worry-warts right?
Not so fast – energy costs were a huge source of the run-up. Strip them out of the price series together with the volatile food category, and so-called ‘core’ inflation is a bit different. The last two months have seen strong gains, at an annual rate of 3.6 per cent. Over the same seven-month stretch, though, the average is just 2.5 per cent. But aren’t the most recent numbers really what matter? Good point – let’s have a look at the details.
Surprising rise in vehicle costs
Breaking it down into core goods, it’s clear that apparel costs shot up in January. This is likely just a seasonal movement. A more concerning change is the rise in vehicle costs – that may be a signal of something deeper. But remember, in this segment, we were worried about oversupplies and bloated inventories just a year ago; there hasn’t been a lot to indicate significantly tighter supplies since then. However, given capacity constraints in the industry, we will keep this under close scrutiny.
Costs of core services have ramped up recently, but only to the growth pace experienced in 2016, which at the time raised few eyebrows. Shelter costs are definitely above the Fed’s overall price target, but they have been there for awhile. A key mover of core service costs is vehicle insurance, which is on a steady upswing. So far, it’s isolated and as such, not a worry.
Certain hybrid measures of core inflation are a bit more concerning. For example, strip out not only food and energy but also homeowners’ rent and tobacco, and core is rising more than at any point in the post-recession period. A few other hybrid measures come up with the same result. So, are we worried?
I’ve long said that after a very long period of worry about the opposite – disinflation, or worse still, outright deflation – that a little inflation is not a bad thing. Those two dreaded ‘D’ words are ones for which central banks have a very limited playbook. Inflation? They have that one down pat.
That could be cold comfort, though, if it means that a much tighter interest rate stance is needed. Is that where things are going? Again, not so fast. Sluggish post-recession growth – a decade-old reality – has conditioned a lot of economic behavior to expect and therefore prepare for much less than the economy is capable of. Today’s higher growth is a wake-up call that finally more capacity is needed. As we work through this interim adjustment period, it would be natural to experience temporary price increases. Indeed, they are in effect the economy’s call to action. Given the capacity the US has to add to its capacity, and clear evidence of pent-up demand, the Fed’s role is not to stanch out-of-control growth, but to guide a manageable growth upshift.
Preparing for the rate of inflation
How should we prepare for and approach this shift? First, there are likely to be regular moments of price-panic, but given what’s really happening, in each occurrence it should fade quickly. Second, rates will continue to rise – not just at the short end of the market, but increasingly on the long end. Five- and ten-year yields are now on a path that looks a lot more like a return to normal, baking in a rate of inflation at, not below, target level, and also moving toward a more standard risk premium for longer paper. Savvy companies appear keen to lock in lending ahead of what looks like a steady run of increases.
The bottom line?
Prepare for interesting monthly price movements – not just in the US, but across the pond as well. But try to tune out the scaremongers – as far as we can see, this is a welcome by-product of an economy that is finally getting back on its feet. It has been a long wait.