Inflation May Not Be Exactly as It Appears

It might appear that consumer price inflation is slowing. But don't be fooled: The underlying pressure is probably growing. The Department of Labor released on Tuesday the consumer price index report, showing that the core measure only rose by 0.1%, down from 0.3% last month. That left the year-over-year figure at 4% and below consensus expectations of 4.2%. Unfortunately, these headline measures don't tell us much about what trend inflation actually is, and thus don't help us in forecasting interest rates. Here, I'm going to break down the CPI report, and show why inflation should remain a major concern, even if the headline figures slow from here. Transitory Is a Gray Area Before we dig in, let's consider how inflation will matter for both the Federal Reserve and rates markets. Everyone knows that the current eye-popping inflation numbers will fade as pandemic-related effects subside. Even this slower CPI report showed overall inflation at 5.3%, which would certainly have been a shockingly large number just a couple years ago. The real question is what inflation will look like in six to nine months out. By then, the supply chains will probably be in better shape and any reverberations from stimulus spending will be long gone. Fed Vice Chair Richard Clarida recently suggested that if core personal consumption expenditures ran at 2.1% in calendar 2022 that would be enough to start rate hikes in early 2023. So yes, inflation running at 5.3% is transitory. The question is when it subsides, what is the underlying trend. If it is above 2.1%, we're looking at rate hikes. If inflation pressure is powerful enough to persist into 2023 despite rate hikes, it could result in the Fed hiking much more than assumed. Bottom line is that inflation is essential to how interest rates will move going forward, but the fact that slows mildly is of no matter. Signal or Noise? In this CPI report there was clear signs of pandemic-effects waning. Rental car prices fell 8.5%, plane tickets were down 9.1%, hotels fell 3.3%, and used cars slipped 1.5%. These are all prices that shot up earlier in 2021 but we always knew would come back down to earth eventually. If we exclude these items from the core CPI, everything else would have risen 0.28%, or a 3.47% annualized pace. It is very hard to judge what is going to happen to prices in these segments. They might fall back to 2019 levels, or they might remain at some higher base. If this whole group were to completely reverse all of the COVID-era increases, it would represent a 1.49% drag on overall CPI. While this level of decline might not be what actually comes about, I think we should assume this group is going to weight on CPI (and PCE) for a while to come. What to Watch? Wages I've been saying for months that wage growth is the biggest key to knowing if inflation will be persistent. There are two big reasons. The most important is that consumers can only bid up prices if they have more income to spend. So unless wages are rising, inflation can't persist for the simple reason that consumers won't be able to afford higher prices. There's no doubt right now that wage pressure is high, and I believe this pressure will continue. Labor supply appears to very tight and doesn't seem to be getting any better. The second reason why wages are key is that labor is a major cost for most businesses. If companies continue to exhibit the kind of pricing power they appear to have now, then higher wage pressure should translate into more price inflation. To this end I created an index of CPI items produced by highly labor intensive businesses. I limited this to industries where labor is the overwhelming cost of production, and as a result these are basically all services. This includes auto repair, at-home nursing, lawn care and hair salons. I did this not because it is predictive of exactly where inflation is going, but rather because it is the clearest way to tell if wage-related cost-push inflation is happening in real life. In other words, the exact level of this CPI subset isn't very important, but rather to see if it is accelerating or not. Here's What the Data Suggest The chart below puts both of these points together. This charts the rolling six-month annualized inflation rate for all CPI items less those that surged during the pandemic in blue, and my subset of labor-intensive services in orange. Source: Bureau of Labor Statistics Notice two things in this data set. First, it is clear that when you pull out the wildly fluctuating prices for things like used cars and plane tickets, underlying inflation has clearly accelerated during 2021. Over the last six months CPI has run at 4.7% by this measure. Second is how wages are influencing inflation. While this measure decelerated toward the end of 2020, it has also accelerated meaningfully in the last few months. Again, I'm not putting a lot of stock into the precise level of this index, but it appears that firms in this subset are increasingly raising prices. At least within this subset, wage pressure is becoming cost-push inflation. Here's What the Fed Will Do After next Wednesday's Fed meeting, Chair Jerome Powell will probably rehash the themes from his Jackson Hole speech. Recall that one of his points from Jackson Hole was that the recently high inflation prints were driven by a narrow set of products. Here I've shown that this isn't entirely true. Inflation is becoming more broadly evident. Powell is trying to give the Fed some breathing room to make sure that inflation really will be lasting, and that's probably the right thing to do. Hiking too soon is probably more damaging than waiting a little too long. Bu if the trends we see now continue for the next few months, Powell won't be able to keep using this excuse.

Inflation May Not Be Exactly as It Appears

Consumer prices look like they are not growing as quickly. But let's take a closer look at a key area to watch -- and see how the Fed will likely respond.

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