It was a volatile week for all asset classes as investors tried to digest the latest inflation data. Was the spike higher a temporary blip, a sign of things to come, or something in-between? There are no clear answers yet, but it is evident from this week’s gyrations that assets aren’t priced for a durable return of inflation.
What set the cat among the pigeons was the Consumer Price Index (CPI) report. The April core (excluding food and energy) CPI rose 0.92% month-over-month, more than triple the pace expected. The range of estimates from more than five-dozen economists was 0% to 0.4%. On a year-over-year basis the headline number was up +4.16% while core was up +2.96%, as you can see below.
The details were consistent with a huge boost from reopening. For example, hotel lodging was up +7.6%, airfares +10.2%, and car and truck rentals shot the lights out. After all, rental cars in Hawaii are going for $500/day, if you can find one!!
Used car prices are also going nuts. Prices were up +10% for the month (yes, a single month), the biggest increase since records began in 1953 (chart below). This component equals 2.76% of CPI. Thus, the rise in used car & truck prices added about 0.3ppt to headline CPI.
And there could be more to come. Auto industry data shows that used vehicle prices are 54% higher in April than the year prior and used vehicle CPI tends to lag by a few months.
But this brings up a somewhat philosophical point about inflation – are rising used car prices, for example, really inflationary? Presumably, the increases won’t go on forever – we will reach a point where supply equals demand, or maybe the higher prices bring on a surge of supply in the months to come. And how many of us are buying used cars on a regular basis? It’s a price shock for sure. But inflation??
When Does Transitory Become Permanent??
This question really gets to the heart of the transitory versus permanent inflation debate. Are one-time price adjustments inflationary?
For example, the latest inflation data is being exaggerated by base effects. Take a look at the chart below. The price index troughed in May of 2020 at 256. Basically, the economy was in crash mode last April and May so prices collapsed. And now the economy is booming so you have an exaggerated base effect where the numbers look high in large part because we’re comparing it to a severely depressed environment a year ago.
But fast forward a few months and inflation will calm down simply due to harder year-over-year comparisons. This gets to the heart of the idea of transitory inflation the Fed and many others are talking about. Basically, you would need to see a continued surge in some of these unusual items like used cars in order for a 4.2% rate of inflation to persist. That probably isn’t going to happen.
For proof just look at the bond market. The chart below overlays the inflation data on 10-year bond yields. They were up a bit this week, but not much considering the massive inflation report.
Or look at inflation expectations. This is a market-based estimate of where inflation expectations will be in five years for the next five years. It’s about where it was in 2014. Yea it’s up, but expectations are hardly going parabolic.
As JP Morgan noted on Wednesday:
‘However, just as the expected 5.7% global GDP growth for this year represents transitory dynamics, this year’s projected inflation rise reflects a set of temporary pressures related to commodity prices, bottlenecks, and price level normalization. As a result, this year’s bounce, by itself, sheds relatively little light on the medium-term trajectory of inflation, a point now being emphasized by the Fed and other major central banks.’
Whether we agree with this view or not, it’s at least what the market is focused on and what it seems to be pricing in. The market can certainly be wrong – $150 oil in the spring of 2008 right before the global financial crisis was clearly a mispricing in retrospect. But what will move the market from thinking the spike in inflation is becoming a more permanent state of affairs?
Show Me the Money!!
In a word – wages. If we start to see accelerating wage growth then the market narrative could very quickly shift towards permanent inflation. This is why headlines like the ones below get so much attention.
But so far we aren’t seeing much movement in the underlying data. Wage growth has been stuck in the same band since roughly 2015.
Could we see this pick up in the next 12-to-18 months. Almost certainly, but not before the labor market gets tight. Granted there is a lot of talk about a shortage of workers due to extended unemployment benefits, but if we had to guess, durable wage gains won’t materialize until total employment in the U.S. gets back close to the March 2020 highs.
This could be the story for 2022, but who really knows. Coming out of the financial crisis we didn’t recoup all the job losses until September 2014, six-and-a-half years after the crisis ended.
But for the markets that are drinking at the well of never-ending liquidity, what really matters isn’t so much inflation, but how will the Fed and other central bankers react to the data. This brings us to the following quote from one our favorite Fed analysts, Tim Duy:
‘For the Fed, everything remains transitory. Firmly fixated on the goal of full employment, the Fed remains committed to its ‘credibly irresponsible’ policy approach. Unless the supply side crunch eases quickly, the Fed will be under increasing pressure to shift its stance in a hawkish direction. My concern is that the Fed will deny, deny, deny before shifting gears quickly. Still, the Fed has not as yet signaled it will waver. The marching orders are clear: everything and anything is transitory. It is time to question if the Fed really follows and outcome-based policy. In practice, the Fed has defined a minimum standard for full employment that is effectively the pre-pandemic employment to population ratio. That definition allows the fed to justify its forecast of any and all upcoming inflationary pressures as transitory. Any evidence to the contrary is summarily dismissed. Any economic outcomes now that don’t fit into the ‘inflation is transitory and fully employment is fixed at pre-pandemic levels’ narrative doesn’t seem to have impact on policy thinking.’
For the time being the liquidity pumps are working overtime.
The key question is what causes the Fed to change their tune? Time will tell.
Charts We Found Interesting
1. Case counts continues to fall.
2. In late January the UK was averaging 1,250 covid-19 deaths per day. Over the last week, that has moved down to 9 deaths per day. A 99.3% reduction in less than 4 months.
3. Pubs are open again in the U.K. T.V. personalities take their pet lamb out for a pint. Lockdowns have been hard on some people apparently.
4. Easy to remember.
5. Retail sales wiffed in April, but the long-term chart is one of the most amazing charts around.
6. Not all interest rates have gone up – adjustable mortgages are near their all-time lows. More fuel for the housing market.
7. There are plenty of jobs out there. This week’s JOLTS job openings figures increased by 597,000, to an all-time high of 8.123 million in the month of March. Job openings are roughly 14% higher than at the start of 2020.
8. Where does the water go in California? Farms, mostly.
9. It’s going to be a long dry summer – ‘CA Fire Crews Find Sequoia Tree Still Smoldering From 2020 Blaze.’
Have a good weekend.
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