US inflation soars, but will it reverse?
- Inflation in the United States continues to accelerate, hitting another 40-year high. Equity and bond investors reacted with pessimism, driving down equity prices and driving up bond yields. Many investors had expected that inflation would rise in January from December, but it rose more than expected, thereby spooking markets.
Here’s what happened. The government reported that consumer prices were up 7.5% in January versus a year earlier, the highest since the early 1980s. Prices were up 0.6% from December to January, the same as in the previous month, but lower than in October and November. Thus, month-to-month inflation evidently peaked a few months ago, but the base effect from a year ago has rendered the 12-month change at an historic high.
Food and energy prices rose sharply in January, and the two were related. Energy prices were up 27% from a year earlier and up 0.9% from the previous month. The sharp rise in energy prices in the past year likely fed into food prices as food production is highly energy intensive. The result is that food prices were up 7% from a year earlier and up 0.9% from the previous month. When volatile food and energy prices are excluded, core prices were up 6% from a year earlier, which was a 40-year high. Core prices were up 0.6% from December, the same as in the previous month.
In the press, much was made of the acceleration in the price of rental housing. The price index of renting residential property was up 3.8% in January versus a year earlier, the highest in two years. The price index for the imputed rent of owner-occupied housing was up 4.1% from a year earlier, the highest since 2007. This important indicator is meant to measure the housing component of consumer prices. A large majority of Americans own their homes and don’t buy and sell homes frequently. Thus, to measure the housing component of inflation, the government surveys homeowners and asks them what they would charge if they were renting out their homes. Given that home prices have increased sharply in the past year, homeowners evidently believe they can command higher rents than previously. This measure moves slowly over time, but it clearly has accelerated. This could make it more difficult for inflation to abate in the coming year or two.
Still, despite a modest acceleration in the cost of housing, the main culprit in today’s inflation story remains durable goods. Specifically, the price index for durable goods was up 18.4% in January from a year earlier and up 1.3% from December. Prices of nondurable goods were up 9.8% from a year earlier and up 0.6% from December. On the other hand, the price index for nonenergy services was up only 4.1% from a year earlier and up 0.4% from December. This suggests that inflation remains a supply chain story, driven by the challenges of producing and transporting a sufficient quantity of goods to meet the surge in consumer demand. Recall, during the pandemic, most consumers shifted dramatically away from spending on services and toward spending on goods. This helped to fuel inflation for goods, which persists today. The hope of the Federal Reserve is that, over time, supply chain disruption will abate while consumer demand shifts back toward services. If this happens, inflation will decelerate. In fact, Fed Chair Powell has said that he expects a significant improvement in supply chain efficiency in the second half of this year.
Some of the details of the report are quite interesting. For example, the price index for used cars was up 40.5% from a year earlier and up 1.5% from the previous month. For new cars, prices were up 12% from a year earlier but were down 0.2% from the previous month. Car rental prices were up 29.3% from a year earlier but down 7% from December. On the other hand, prices of smartphones were down 13.3% from a year earlier while prices of cosmetics were down 1.7% from a year earlier.
Market reaction to the report was swift and considerable. Many investors viewed the report as boosting the likelihood that the Federal Reserve will increase short-term rates soon and often during 2022. The latest future prices reflect an expectation that the Fed will implement a 50 basis point increase in March and will boost rates by 1.5 percentage points in 2022. Such an aggressive stance would still leave the benchmark rate below 2% by the end of this year. An expectation of rising short-term rates led to higher bond yields, with the yield on the 10-year Treasury bond hitting 2% today for the first time since mid-2019. Still, bond yields remain historically low, likely due to investors’ continued expectation of modest inflation in the long term. Equity prices fell sharply on expectations of higher interest rates.
What about the Fed? The president of the Federal Reserve Bank of Cleveland, Loretta Mester, said that “the task before us is to remove accommodation at the pace necessary to bring inflation under control. As this process continues, our monetary policy decisions will need to be data-driven and forward-looking.” The reality is that a quick tightening of monetary policy will not likely influence the factors currently driving inflation. But an extreme tightening could undermine economic recovery, thereby eventually slowing inflation.
I believe that the role of the Fed right now is to anchor expectations of inflation. So far, investor expectations of inflation remain tame. The 10-year “breakeven rate,” an excellent measure of bond investor expectations of inflation, remains roughly where it was in June when inflation was very low. Thus, many investors have not yet panicked. But if expectations by workers and employers change significantly, there could be a wage-price spiral that would fuel continued inflation. This has not happened yet, but it could happen if inflation persists longer than expected. The labour market in the United States is very tight, as evidenced by a low unemployment rate and a high job vacancy rate. And, although wages have accelerated, they have not risen fast enough to fuel more inflation. Moreover, productivity growth has accelerated, helping to offset the inflationary impact of rising wages.
What the Fed does now will have global implications as it will drive interest rate differentials that can affect currency values. Emerging countries are especially vulnerable to Fed action and many have already boosted their benchmark interest rates, thereby risking an economic slowdown.
Finally, I continue to believe that inflation will gradually abate in 2022 and 2023 as supply chain difficulties recede. This view is shared by the Federal Reserve, other central banks, the IMF, and the OECD. Still, it is a lonely position. Often, participants in the market economy are afflicted by what we economists call adaptive expectations. That is, they base their expectations for the future on what happened in the recent past. We have only had about six months of accelerating inflation, but some observers now expect a decade of high inflation. They might be right, but the evidence still suggests otherwise. Nevertheless, things could still go wrong. Another outbreak of a new variant of the virus could undermine inflation predictions. So would a Russian invasion of Ukraine, which would likely result in much higher oil prices.