The May CPI data exceeded expectations with headline and core CPI jumping 5.0% and 3.8%, respectively. Pricing power is a key differentiator today with consumers flush with cash willing to spend and firms choosing to pass on those costs to consumers. Eventually, the pass through of higher costs should slow. Yet the US Fed’s position that the current inflation spike is “transient” will not mean it is fleeting. On the policy front, the FOMC should officially begin taper discussions at its late-July meeting.
The May consumer price inflation (CPI) print handily exceeded expectations once again. At 5.0% and 3.8% YoY, respectively, the headline CPI inflation rate was the highest since August 2008 and the core rate (excluding food and energy) was the highest since June 1992. One thing is clear: the US inflation spike may be transient, but it is certainly intense (Figure 1).
Economists and policymakers alike tend to look through big swings in the headline inflation rate since it fluctuates widely alongside oil prices. Still, it is noteworthy that headline inflation today is within striking distance of the 2008 peak even though West Texas Intermediate oil prices are roughly half of where they were then. It is, however, the rise in core inflation that truly differentiates today’s experience from that of the post Global Financial Crisis (GFC) recovery. And this is where we must look to try to understand how transient this current inflation surge truly is.
There is no doubt that temporary factors are exacerbating the inflation surge at the moment. Base effects are real and so are supply chain constraints and the release of pent-up demand in services. It is what pushed used car prices up by 20% over the past year and is now driving the sharp acceleration in airfares and lodging costs.
But there is more than base effects and supply chain constraints driving inflation at the moment. After all, base effects also played a role in the post-GFC inflation pick-up, yet we never saw core inflation get this high. What we have today but did not have back then is pricing power. We have written about this before and it is a critically important distinction. Whether companies absorb rising input and labor costs or pass them onto their customers makes all the difference in the world. And in today’s world, with consumers flush with cash and eager to spend, firms are indeed choosing to pass those costs onto their customers.
The National Federation of Independent Business’s survey recently showed that a higher share of small business has raised prices in the past three months and a higher share plan to do so in the next three months than at any time since the early 1980s. Pricing power seems to have permeated even areas of the economy that have been mired in technology-driven deflation for decades (Figure 2).
Eventually, these forces will moderate, base effects will start working in the opposite direction (i.e., depressing the YoY comparisons) and the pass through of higher costs will slow, if not altogether pause. In this sense, the US Fed’s position that the current inflation spike is “transient” is justified. However, transient does not mean fleeting and it could take us well into 2022 to reach that point. And then, even as goods inflation moderates, we could see the currently tame shelter costs becoming a powerful driver of inflation.
So far this year, shelter costs—and owner equivalent rent specifically—have been entirely disconnected from surging house prices (Figure 3). That gap should narrow materially over the next 18 months as distortions from rent and mortgage forbearance wash out of the data and normal market behavior returns. Watch this space to help determine how quickly inflation normalizes.
The Federal Open Market Committee meets next week and this inflation outcome will undoubtedly be a key point of discussion. The committee members may not officially begin taper discussions yet, but we think they really would do so at the late July meeting. Since there will be a time lag between when the discussions start, when tapering is announced and when it actually starts, initiating that first leg of the process sooner rather than later would give the committee more flexibility in managing the entire sequence of events.
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