Last quarter we wrote an article on US inflation and in particular what it would take for inflation to get back to 2-3%. Without wanting to rehash that article, the key conclusion was to get inflation back to 2-3% probably required a reasonably large global recession.
Suffice to say, the quarter since, inflation hasn’t gone away as item at the forefront of investor’s minds.
One development over the last quarter is a material moderation in oil prices. Oil was circa US$110 per barrel at the time of our last newsletter and has fallen to sub US$90 (on a WTI at Cushing basis), a circa 20% fall.
The good news from this is that this has fed into headline CPI, leading to a moderation in headline inflation (see chart below). In the absence of some spectacular new spike in oil prices (eg a new escalation in the Russia/Ukraine situation), it is likely that the peak in headline CPI was in June 2022.
The $64,000 question for investors will be how quickly does it moderate from here (and to what level).
A concerning datapoint in this regard was the increase in core CPI – to 6.3% - in the August CPI release.
The biggest driver of core inflation is wages. That is, higher wages growth usually drives higher core CPI outcomes. There are a range of wages measures in the US – some quarterly and some monthly. The following chart shows the FOMC’s preferred measure (the employment cost index – only available quarterly) as well as average hourly earnings for payroll and non-supervisory employees (available monthly).
While the monthly data has some noise in it due to covid lockdowns in early 2021, they both measures indicate that wages are heating up. This is not surprising. Unemployment is very low (see chart below) and inflation is high. Why wouldn’t workers be demanding higher pay?
All of this presents a picture that core inflation would be unlikely to moderate until wage inflation also falls.
But what about monetary policy. As central bankers often want to tell us – “Monetary policy acts with long and variable lags”.
The key lags we need to worry about are:
How long before the tightening in monetary policy impacts the labour market, reducing wage inflation pressures; and
In the meantime – while the labour market remains tight – how much of current headline inflation gets built into wage demands – resulting in a wage-price spiral and high ongoing core inflation.
At one level, while the headline CPI position is improving, the key conclusion of last quarter remains intact. That is, for inflation to head back to 2-3%, itis going to take a significant global recession and, for my guess, central banks are following a plan that is going to give us one.