May produced another upside surprise for US core inflation. Yet it’s a heavily consensus view that this is a transitory jump in the areas affected by temporary supply disruptions and reopenings.
The market reaction has been muted and the Federal Reserve (Fed), in its June FOMC forecasts, will likely stick with a return to target inflation when this current spike drops out in a year’s time.
When we discussed the risk of an inflation shock back in March, we thought a 3% core inflation print was possible. Instead we’ve now witnessed a 3.8% year-on-year rise in May. The main surprise has been the surge in used-car prices, which are up 30% over the past year. This has added just over one percentage point to core inflation.
Less surprising has been the recovery in hotel prices and airfares, but we’ve continued to see price pressures across a range of goods due to strong stimulus-induced demand, extremely lean global inventories, supply disruptions, and semiconductor shortages.
We expect the Fed to continue to draw comfort from a median Consumer Price Index (CPI) in May of only 0.3% month on month and a steady 2.1% year on year. Trimmed mean CPI (which strips out the outliers either side) is edging up, but only to 2.6%. Some of the large stickier elements of inflation, such as education services and healthcare, remain subdued.
Overall core CPI inflation is highly likely to stay above 3% over the next year. The base effects from falling prices during the pandemic last year are now behind us, but there should still be some more reopening normalisation to come and not much sign at this point that used car or other spiking prices are about to reverse.
So there’s an uncomfortable period ahead which risks affecting broader inflation expectations and wage and price-setting behaviour. This is at a time when the labour market appears to be suffering from its own bottleneck pressure.
We think developments in rent will be important given its large 40% weight in the core CPI. While recent prints have firmed, it’s unlikely to increase dramatically due to the calculation methodology even though actual new rent contracts on the ground appear to be rising quickly and the housing market is booming.
The base case is that Fed credibility, increasing labour supply over the summer and autumn when the unemployment benefits expire, and some other underlying disinflationary forces prevent a wage-price spiral developing, though the risk is rising that these transitory increases run into an economy which begins to overheat in 2022.
The price rises seen over the past two months are unlikely to be repeated and some, such as vehicle-rental prices, should even fall back at some point. This could push down inflation just as the base effect from the recent spike drops out. Core CPI should therefore ease back towards 2–2.5% (and core PCE to around 2%) in the second half of next year, even as underlying inflationary pressure is building.
On a longer-term basis, we believe the inflation risks remain to the upside relative to target as the US labour market becomes extremely tight, rent inflation climbs, and the global output gap closes.
However, should more persistent inflation pressure begin to emerge sooner, we’re confident that the Fed will perform a (potentially very market disruptive) policy pivot to prevent a more serious outbreak (i.e. sustained inflation above 3%). But to draw this conclusion will likely take several months as the Fed would need to be convinced that it has grossly misjudged the amount of labour market slack and the wage and price-setting process.