Inflation in the United States and Australia (and most parts of the rest of the world) has broken out from the 2-3% typical range of the past few decades. For the 12 months to end May, inflation in the US was 8.6%. The RBA governor recently predicted inflation could exceed 7% in Australia. This has put bond markets in a tailspin as market participants scramble to guess the future path of monetary policy and interest rates in light of this inflation shock.
At the core of this are two questions:
· What will central banks need to do to get inflation under control?
· What level, that is medium term inflation rate, will inflation revert to after the current spike?
These are really hard questions.
Instead, this article tries to ask a closely related – but easier question. The question we are going to try to answer is what would it take to get inflation back to 2-3%? For this discussion, we are going to focus on the US CPI data, but most of the issues discussed would apply reasonably equally in Australia.
The chart below shows the US annual CPI over the past decade and also the key contributions to that outcome, split between goods, food, energy and services.
For the period 2012 to 2021, inflation in the US was incredibly stable at around 2%. This outcome was almost entirely driven by the rising cost of services. That is, wages grew steadily and the cost of increased wages fed through to services inflation (given that the biggest cost of services is labour). For the nine years to 2021, this was basically all of CPI. Goods and food prices over this period were basically flat (i.e. not contributing to inflation).
Over these nine years, there were periods where energy was a significant addition or detraction to CPI, and this pushed inflation above or below the 2% trend for a while.
Where the chart gets interesting, is in 2021. That is, when the US economy started re-opening post Covid lockdowns. Over the last year inflation has exploded.
This is driven by four factors:
- Wages (and labour shortages) have seen services inflation rise moderately – up to 3% or so compared to the 2% long-term trend.
- Goods prices have exploded and are a material contributor to inflation for the first time in decades. This reflects supply chain shortages as Covid (or Covid government stimulus) sees a big substitution from services to goods (ie, everyone buys a bread maker during lockdown rather than going out to a restaurant – or for Australians, we buy a house).
- Food prices jump. This reflects a range of factors, including the strong link between food and energy (energy is a big cost contributor to food prices) as well as the impact of the Russia/Ukraine conflict (and those countries role as food and fertiliser exporters).
- Energy prices explode. This reflects the Russia/Ukraine conflict as well as likely underinvestment in the energy sector over the past five or six years (ie post the collapse of the US shale sector in 2015 and 2016) which has been highlighted by the rebound in energy demand as the global economy reopens post Covid.
This is how we have got to 8.6% inflation in the US in May 2022. But what happens from here and what would it take to get back to a 2-3% annual rate?
Mathematically this is simple – you need average prices rises to fall to 2-3%. Duhh.
But the point I am making is that so called base effects are powerful. Energy prices simply remaining where they are now – not continuing to rise from their already elevated levels – would see the energy contribution to CPI drop to zero over 12 months.
This is quite possible. We are not making a forecast one way or the other, but it is quite possible.
Similarly, spending could shift from goods back to services as travel reopens (and who needs two bread makers). This could see goods switch from being a contributor to CPI to a detractor (and this would be consistent with the recent profit warnings from big US retailers like Target and Walmart). However, it is not just Covid that has driven goods price rises, the reversal of globalisation (tariff barriers and re-onshoring of production), are also drivers of inflation. Thus, goods inflation might be a bit stickier than you think.
But putting it all together, what would you need to happen for CPI to be back at 2-3% in one or two years time? In my view, it would require:
- a recession so wage growth falls back, which would see services contribution to drop back to 2% instead of 3%; and
- Goods ex food and energy back to zero or even a mild negative. That is, back to full globalisation (or more likely, some ongoing supply/trade snarls, but more than offset by a global recession); and
- Food is probably going to still be a positive contributor. Food shortages caused by Russian/Ukraine (both direct and indirect through fertiliser supply chain) seem hard to fix quickly; and
- that basically means to get to 2-3% total inflation would need energy to be a reasonably big net negative. That is, energy prices something like 2015 when oil went from $100 to $50. This is not impossible – it is important to remember that oil (and energy) is a price inelastic good. Russia is only about 10% of global oil production – and the net reduction in Russian supply as a result of sanctions is only a small portion of this – but this disruption has seen a 30%+ spike in oil prices. Thus, it might only take a relatively small amount of demand destruction (through a recession) to have a quite significant impact on oil/energy prices. A reproachment between Russia and the west wouldn’t hurt either.
In conclusion - it is quite possible for CPI to revert to 2-3%, but you need to have a reasonably large global recession to get this outcome. There are signs on the fringes that this might occur – EU is in a very sticky situation and the growth outlook in China is uncertain with continued lockdowns. It will be interesting to watch how quickly US growth responds to rising interest rates.
One thing you can say for certain, is that 2-3% medium term inflation is not consistent with a soft landing in the US. If the US slows growth/demand slowly then:
- Wages and labour markets stay reasonably robust -services CPI remains closer to 3% than 2%; and
- Oil prices stay high – no net detraction from CPI from energy (and in a worse case, a re-opening of China and its associated oil demand could see oil prices take a leg higher);
- which means to get to 2-3% inflation you need net detractions from CPI from goods and food like you haven’t seen in last decade. For goods in particular it doesn’t make sense, outside of a recession, that you would have a rapid detraction from CPI.
This view is consistent with the market consensus. The chart below shows implied inflation from US inflation swap curves. Note the back end of this chart, where market expectations of inflation post the current spike are gradually shifting up.
It is this shift that is particularly scaring bond markets.
