- US CPI inflation smashed expectations for a 4th straight month
- Some factors may be transitory for uncertain periods…
- ...but don’t ignore the ones that either may not be transitory…
- ...or that haven’t even begun to exert upward pressure
- US front-end yields rise on brought-forward Fed hikes…
- ...while longer term yields fall partly on classic exit flatteners…
- ...but are too distorted by scarcity and liquidity issues into the debt ceiling crunch to be taken at face value
- Defining ‘transitory’ and cycle views
US CPI, m/m % // y/y %, June:
Actual: 0.9 / 5.4
Scotia: 0.5 / 4.9
Consensus: 0.5 / 4.9
Prior: 0.6 / 5.0
US core CPI, m/m % // y/y %, June:
Actual: 0.9 / 4.5
Scotia: 0.4 / 4.0
Consensus: 0.4 / 4.0
Prior: 0.7 / 3.8
US core inflation sharply exceeded consensus expectations for the fourth month in a row. The US Treasury yield curve steepened at first with 10s selling off by about 4bps before a second flattening trade swooped in to make the curve flat on the day while the dollar has sustainably appreciated.
TREASURY CURVE FLATTENS
It’s not fully clear to me whether that second trade was motivated by buyers who think the upside surprise was transitory (again….) or whether it was motivated by buyers who think the upside surprise brings forward Fed rate-hike expectations. The cheapening in US 2s would lend support to the latter interpretation but my view remains that the longer-end is too distorted by excess liquidity and expected scarcity into debt ceiling issues to be able to take a classic view of the curve. For that, we might have to wait until later in the summer if and when the debt ceiling issue is addressed and how. That uncertainty should temper bond market viewpoints.
WHAT DROVE IT?
Regardless, this is another report that humbles a model-based approach to forecasting inflation in a reopening economy with historic amounts of monetary and fiscal stimulus being applied to damaged supply chains. The Phillips curve is parked on the shelf during this period. It’s exceedingly difficult to estimate such price pressures in a massive out-of-sample experiment, but at a minimum we can provide honest assessments of the underlying drivers and opinions on where to from here.
Chart 1 shows soaring core inflation in year-ago terms and how the correlations will see core CPI translate into a hotter core PCE reading on July 30th (probably over 4% y/y). A lot of central banks in the world would have already tightened on that but I find the Fed is all-in on a binary bet.
Chart 2 shows the annualized month-ago changes in core inflation. This chart vividly demonstrates that the initial tendency for Fed Chair Powell to dismiss all inflation as base effect driven has been demonstrated to be complete and utter nonsense. I’ve long emphasized the importance of looking to this measure instead of the year-over-year rate when evaluating incremental price pressures.
Chart 3 shows the extent to which the FOMC’s inflation forecasts have been so far off from reality. Everyone knew the base effects as we were forecasting inflation for this year over the past year, so clearly the massive upside beats represent lowballed assessments of incremental price pressures. San Fran President Daly—a dove with a strong labour market background—commented after the release that the Fed expected higher inflation. Uh, righto…. That is a serious misrepresentation of FOMC forecasts.
Daly also commented that these forces are temporary, but this is a significant area of uncertainty across the broader FOMC. For instance, Richmond Fed President Barkin noted after CPI that higher wages of lower-income workers due to “stubbornly low” workforce participation are helping to drive inflation and that it will take until around late summer in order to more carefully evaluate the risks to inflation. In my view, the overall FOMC has been spending too much time talking up estimates of labour slack and talking down inflation and inflation risk to date, though less so more recently. It should be transitioning toward less bond buying now or very shortly as per the views of others like Kaplan and Bullard. Onto Powell tomorrow.
Charts 4 and 5 show that most of the inflation continues to be derived from the goods side of the economy and do so in both year-over-year and month-ago terms. 65% of total consumption is made up of services and remains underweighted due to the pandemic. As the services economy reopens, we may well see a) this weight rise, and b) services inflation accelerate which means that unless you’ve got a large book of bonds to foist onto the unsuspecting then one should remain very guarded toward the transitory argument.
Where did inflation come from this latest month? Charts 6 and 7 (next page) help to answer that question by showing the weighted and unweighted contributions to month-over-month seasonally adjusted prices. The hottest weighted pressures last month came from vehicles (used and new) and gasoline plus housing through owners’ equivalent rent and lodging away from now.
Charts 8 and 9 (page 4) do the same thing for the year-over-year changes in prices and yield some similarities and differences.
The remaining charts on the last page seek to illustrate drivers that are a mixture of possibly transitory upsides and transitory downsides with comments throughout.
While vehicle prices were the hottest contributor (chart 10), don’t overstate their role. In weighted terms, used vehicle prices added 0.3% m/m to headline CPI, leaving the other six-tenths or about two-thirds of the spike in prices to be explained by other factors. New vehicle prices added 0.07% to m/m CPI for a minor additional role. Further, how transitory vehicle price inflation may be is highly uncertain given the scale and scope of damage to vehicle supply chains including but not limited to chip shortages.
Food-at-home prices are correcting off the year-ago surge (chart 11). This illustrates that we’ve already seen some of the transitory upward influences having been eliminated. The year-ago stockpiling effect is causing base effects that are driving this category lower now in year-over-year terms.
Chart 12 shows that supply chain issues are reaching beyond vehicles as washing machine prices continue to rise sharply. There is a tiny weight on this category, but it could be treated as symptomatic of supply chain issues that go well beyond vehicles. My household has been waiting over 2 months for delivery of a new stove.
Chart 13 shows that after years of soaring prices, prescription drugs are falling in year-over-year terms. I’m not sure that will continue but would note its potential to be an upside driver over the cycle.
Chart 14 shows rising cell phone service prices that may be due to the pandemic and may be transitory. If demand picks up with a job recovery then that could mitigate some of this transitory argument.
Chart 15 shows the extent to which medical care inflation—with a CPI weight of just under 9%—has swung toward sharply disinflationary forces. Given the multi-decade tendency for medical care prices to rise I wouldn’t count on this drag effect being persistent especially with an aging population and cost pressures from new technologies and treatments.
Chart 16 shows rising apparel prices. We would expect to see further upward pressure along with return to office effects and greater mobility and so it’s highly premature to view this driver as transitory.
Chart 17 shows that airfare prices are on an upswing. It’s unclear how transitory this may prove to be as business and consumer travel returns along with vaccines.
DEFINING TRANSITORY AND CYCLE VIEWS
Throughout one’s assessment of these and other drivers of US inflation, a parting point involves emphasizing how to view and define transitory. I don’t define it as something to be settled within, say, six months versus a full-cycle perspective. It doesn't matter to me if inflation may pull off such heights within that time frame since monetary policy is supposed to look at the fuller cycle. Second, it’s not transitory to me even if inflation falls back to half this rate over the cycle on average since that would still make it exceptionally challenging to support present levels of stimulus if inflation ebbs but averages out around the target.
As for longer run drivers, my view remains that tendency to look back in time to forces that kept inflation low may not hold in future. Demographics is probably shifting toward being inflationary as higher older age dependency ratios drive price inflation. Trade policy has not been focused upon liberalizing trade since China’s ascension to the WTO and if anything is turning more protectionist. Technological change may also be facing fundamentally different forces through the rise of digital companies and hence the public policy focus in N.A., Europe and even China upon curbing powers. Add in damaged supply chains that will likely be damaged for the cycle by the pandemic and prior trade wars, plus historic stimulus and it seems to me the inflation risk remains tilted to the upside over the cycle.
DISCLAIMER
This report has been prepared by Scotiabank Economics as a resource for the clients of Scotiabank. Opinions, estimates and projections contained herein are our own as of the date hereof and are subject to change without notice. The information and opinions contained herein have been compiled or arrived at from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness. Neither Scotiabank nor any of its officers, directors, partners, employees or affiliates accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or its contents.
These reports are provided to you for informational purposes only. This report is not, and is not constructed as, an offer to sell or solicitation of any offer to buy any financial instrument, nor shall this report be construed as an opinion as to whether you should enter into any swap or trading strategy involving a swap or any other transaction. The information contained in this report is not intended to be, and does not constitute, a recommendation of a swap or trading strategy involving a swap within the meaning of U.S. Commodity Futures Trading Commission Regulation 23.434 and Appendix A thereto. This material is not intended to be individually tailored to your needs or characteristics and should not be viewed as a “call to action” or suggestion that you enter into a swap or trading strategy involving a swap or any other transaction. Scotiabank may engage in transactions in a manner inconsistent with the views discussed this report and may have positions, or be in the process of acquiring or disposing of positions, referred to in this report.
Scotiabank, its affiliates and any of their respective officers, directors and employees may from time to time take positions in currencies, act as managers, co-managers or underwriters of a public offering or act as principals or agents, deal in, own or act as market makers or advisors, brokers or commercial and/or investment bankers in relation to securities or related derivatives. As a result of these actions, Scotiabank may receive remuneration. All Scotiabank products and services are subject to the terms of applicable agreements and local regulations. Officers, directors and employees of Scotiabank and its affiliates may serve as directors of corporations.
Any securities discussed in this report may not be suitable for all investors. Scotiabank recommends that investors independently evaluate any issuer and security discussed in this report, and consult with any advisors they deem necessary prior to making any investment.
This report and all information, opinions and conclusions contained in it are protected by copyright. This information may not be reproduced without the prior express written consent of Scotiabank.
™ Trademark of The Bank of Nova Scotia. Used under license, where applicable.
Scotiabank, together with “Global Banking and Markets”, is a marketing name for the global corporate and investment banking and capital markets businesses of The Bank of Nova Scotia and certain of its affiliates in the countries where they operate, including; Scotiabank Europe plc; Scotiabank (Ireland) Designated Activity Company; Scotiabank Inverlat S.A., Institución de Banca Múltiple, Grupo Financiero Scotiabank Inverlat, Scotia Inverlat Casa de Bolsa, S.A. de C.V., Grupo Financiero Scotiabank Inverlat, Scotia Inverlat Derivados S.A. de C.V. – all members of the Scotiabank group and authorized users of the Scotiabank mark. The Bank of Nova Scotia is incorporated in Canada with limited liability and is authorised and regulated by the Office of the Superintendent of Financial Institutions Canada. The Bank of Nova Scotia is authorized by the UK Prudential Regulation Authority and is subject to regulation by the UK Financial Conduct Authority and limited regulation by the UK Prudential Regulation Authority. Details about the extent of The Bank of Nova Scotia's regulation by the UK Prudential Regulation Authority are available from us on request. Scotiabank Europe plc is authorized by the UK Prudential Regulation Authority and regulated by the UK Financial Conduct Authority and the UK Prudential Regulation Authority.
Scotiabank Inverlat, S.A., Scotia Inverlat Casa de Bolsa, S.A. de C.V, Grupo Financiero Scotiabank Inverlat, and Scotia Inverlat Derivados, S.A. de C.V., are each authorized and regulated by the Mexican financial authorities.
Not all products and services are offered in all jurisdictions. Services described are available in jurisdictions where permitted by law.