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Inflation: Just Passing Through, or Here to Stay?

As the US economy fully reopens and folks are able to return to their traditional spending patterns (to what degree only time will tell), price increases for a number of goods and services should not be a surprise. Indeed, many have seen it coming for a while. After all, we appear to be witnessing a classic example of supply and demand driven price movement: The pandemic’s impacts on global supply chains, production capacity, inventories and labor markets haven’t been fully resolved before businesses hurry to fully reopen and consumers rush to shop at stores, eat at restaurants and travel.

Nonetheless, the May Consumer Price Index (CPI) jump of 5.0%—the largest annual increase since 2008—was more than most expected. Excluding food and energy, consumer prices rose a greater-than-expected 3.2% YoY. And the gains weren’t due purely to base effects of pandemic- and lockdown-driven inflation weakness a year ago. The overall index rose 0.6% on a monthly basis and 0.7% excluding food and energy. The May numbers build on an April CPI report that showed inflation running faster than expected.

Digging into the numbers, some of the biggest MoM price increases weren’t a huge surprise: airline fares, used cars and trucks, vehicle rentals, as well as the moving, storage, freight expense category. Prices for hotels and motels and sporting events posted more modest gains in May but those came on top of large increases in April. And it is still fair to wonder if the latest increases are truly inflationary or more reflationary in nature—a recovery in prices after the economic shock last year. Take gasoline, up 56.2% YoY in the CPI report, but the national average price per gallon in May was in line with pre-COVID April prices in 2019 and 2018.

Going further up the supply chain, markets will now pay a lot of attention to the May Producer Price Index report on June 15. The April reading was up 6.2% YoY. Similar to the CPI, the jump wasn’t primarily driven by base effects, but rather by a handful of items, such as steel mill products; transportation of passengers; meat (beef, veal and pork); as well as hardware, building materials, and supplies retailing—likely due partly to surging lumber prices.

Elevated CPI and PPI numbers haven’t fundamentally changed the broadly held view that the pickup in inflation will be transitory—to use the Fed’s word du jour—but they do elevate some important questions. How long is transitory in this situation? Is there a risk a near-term inflation spike has a more lasting impact? And how much inflation will investors and the Federal Reserve stomach before adjusting their strategies?

In terms of duration, it seems markets generally expect inflation to settle down by the end of the year. But some in the Fed seem open to inflation running above its 2% long-run target until 2023. Going forward, if the CPI averages its long-term monthly increase of 0.2%, inflation would be 2.4% YoY at this time in 2022. If CPI runs just a little hotter, averaging 0.3% per month, CPI would be around 3.7% a year from now.

Inflation expectations have also heated up—the University of Michigan’s Inflation Expectations survey shows consumers expect inflation above 3% in the next 12 months. While five-year  and 10-year breakevens have eased in recent days, they imply bond traders see an inflation above 2% for the foreseeable future.

Even so, most economists would say inflation pressures are unlikely to persist unless there are corresponding wage gains to keep fueling price increases. Right now, a record number of job openings indicates businesses are struggling to fill positions, with some employers hiking wages to lure workers. If such wage increases become more widespread, businesses may feel more pressure to raise prices—or else let costs eat into profitability—while enough consumers may be more willing to pay them, opening the door to higher prices even without increased consumer demand.

The Fed doesn’t seem concerned that it may fall behind the inflationary curve. Vice Chairman Richard Clarida recently stated the central bank is willing to let inflation run above its target for a while before raising rates in order meet its maximum-employment mandate and ensure inflation expectations remain anchored around 2%. And more recently, Fed Governor Lael Brainard sounded equally at ease with the Fed’s current stance.

But the Fed is managing a historically tricky moment while switching its inflation targeting approach. Instead of a clear 2% inflation target, it is looking to “achieve inflation that averages 2% over time.” Giving itself more flexibility could allow for higher inflation volatility and more room for error, especially with its other mandate of achieving maximum sustainable employment. It’s certainly something markets will have to account for, whether inflation is just passing through or not.