Friday 11 June 2021

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Economic Environment - Rising inflation in the United States: Temporary, but until when?

Inflation accelerated sharply in April in the United States, mainly due to base effects and price adjustments due to the reopening, which are not expected to persist over time. This is the narrative the Fed says it believes to justify its very patient approach to monetary policy normalization. However, disruption of supply chains and labor market shortages, if they were to persist, could be a game-changer.

 Economists and pundits were very surprised by the April consumer price index (CPI) figures: total inflation rose by 4.2% over the last 12 months (highest level since September 2008) and core inflation (excluding energy and food) by 3% (highest level since December 1995).

The acceleration in inflation in the latest figures comes overall from three factors:

  • Energy-related base effects. As a reminder, the price of oil deliveries moved into negative territory in April 2020 and the rebound in oil prices propelled the CPI energy to +25% over one year in April, the highest level since 2008. Here, it is clearly a transitory factor, which should fade (slowly) from June (publication of the figure in July).
  • Price adjustments related to the reopening. The prices of plane tickets and of lodging away from home, which had fallen sharply with the pandemic, due to the collapse in the number of trips, are normalizing with the reopening and therefore contribute to the rise in the core CPI. Here, there is still a little to be expected in terms of upward contribution of the core CPI since the prices of plane tickets were still 18% lower in April compared to their levels of February 2020 (6% for the price of hotels).
  • Bottleneck issues. The most notable element here concerns the very sharp rise in used cars prices, due to the pent-up demand following the crisis and the drop in production in recent months due to semiconductor shortages. This rise in car prices itself driving up the prices for car rentals and auto insurance. For now, less than half of the increase in the Manheim used vehicle price index appears to have passed through the CPI, indicating that this should contribute more to the rise in the core CPI in the coming months.
IN ALL LIKELIHOOD, THE MAY INFLATION FIGURES (RELEASED IN JUNE) WILL BE A BIT STRONGER AND THE CORE CPI STILL HAS ROOM FOR IMPROVEMENT IN THE COMING MONTHS.

For the moment, FOMC members consider that the rise in inflation "largely reflects transitory factors" and therefore this justifies a very patient approach in terms of withdrawing accommodative monetary policies: in short, it does not justify rushing to slow down its asset purchases (the so-called “tapering”).

This is what constitutes our central scenario, with a possible announcement of the "tapering" at the Jackson Hole conference (August 26-28). The essence of the Fed's philosophy, expressed by Jerome Powell at the Jackson Hole 2020 conference, is that after decades of disappointment with inflation, the Fed remains skeptical about the materialization of inflation rates that would be persistently above 2%.

However, some recent developments encourage us not to rule out an alternative scenario where inflation rises more than expected, which would push up inflation expectations and prompt the Fed to tighten its policy much faster than expected.

Some of the factors that can make inflation more persistent include:

  • Gasoline prices. Since November, gasoline prices at the pump have been rising steadily (at their highest since 2014) and the energy-related base effects could dissipate much less quickly than expected. 
  • Used vehicle prices. While it seems reasonable to assume that the prices of used vehicles will eventually start to fall again, recent developments point to a continuation of the very rapid rise in prices over the first 15 days of May… and auto dealer inventories have never been lower. The longer high prices persist, the more likely it is to impact the price of other goods. 
  • Wage increases. There is growing evidence that companies are struggling to hire and several large groups have announced an increase in entry-level salaries. In April and May, the average hourly earnings of non-managerial employees increased by 0.8%, ie a level which has never been observed between the beginning of the 1980s and 2019. Randal Quarles, Fed Board member, indicated on May 26: "There are wage pressures". Depending on the sector, wage increases are passed on by companies in final prices: in the PCE price index (the household consumption deflator), the prices of food services, a sector in which wages have increased recently, were up 4.6% year-on-year in April, the highest figure since the early 1990s. 
  • Rents. The covid crisis has a very strong impact on the real estate market. Some large cities such as New York or San Francisco initially (and probably temporarily) lost population, some of which moved to the suburbs or to the country. This caused rents to fall sharply there, but with the reopening, they started to rise sharply again. The fact that property prices have themselves risen sharply should lead to rents in the medium term: the property price-torents ratio has thus been at the highest level since at least 1975. Keep in mind that the series of rents and rental equivalents for the owners are the most important item in the market basket.
  • The use of excess savings. The excess savings in 2020/2021 is greater than $2,400 billion (i.e. more than 10% of GDP) and can give rise to a demand for goods and services much greater than the supply that the private sector can assume, which would lead to price increases.
IF INFLATION WERE TO ACCELERATE MORE THAN EXPECTED, THE VARIABLE TO WATCH WILL BE INFLATION EXPECTATIONS,

whether these are market-based or survey-based measures. The stability of long-term inflation expectations is the key indicator of the success of the Average Inflation Targeting (AIT) strategy unveiled by the Fed in the summer of 2020. When this adjustment of strategy2, Jerome Powell had indicated: "if excessive inflationary pressures were to build or inflation expectations were to ratchet above levels consistent with our goal, we would not hesitate to act." T his m eans t hat a r unaway o f e xpectations would push the Fed to tighten its monetary policy in a hasty fashion, to halt its asset purchases quickly and to communicate on upcoming rate hikes. For now, household surveys show that medium/long-term inflation expectations (University of Michigan, New York Fed) have rebounded sharply in recent months but that they do not exceed the levels of the past decade.

Even if the recent rise in inflation can be explained in large part by transitory phenomena (base effects, price adjustments related to the reopening), several developments (gasoline, persistence of supply disruptions for cars, rents, wage increases in certain sectors) mean that a more persistent rise in inflation cannot be ruled out. This would push the Fed to exit more abruptly than expected from its accommodating policies

AN ASSET PURCHASE POLICY THAT NO LONGER SEEMS APPROPRIATE TO THE SITUATION

The Fed responded very vigorously and very quickly from the start of the covid crisis, first by buying very large amounts of Treasury securities to fix the drying up of market liquidity in this market, and then by putting in place investment vehicles (the so-called facilities) which have helped stabilize other market segments (corporate bonds, commercial papers, etc.). From mid-June 2020, the Fed came back to a steady pace of asset purchases of $120bn per month ($80bn in Treasury securities and $40bn in MBS). The Fed has therefore been buying assets on a regular basis for almost a year now, which corresponds to the length of time the Fed carried out its QE3 operation at full speed.

Concretely, the Fed is currently continuing to create central bank money at full speed at a time when it is becoming more and more obvious that it is too abundant: the downward pressure on short rates is increasingly strong and the reverse repo operations (the Fed borrows overnight by posting Treasury securities as collateral) increased sharply over April/May. In short, the Fed posts the Treasury securities it just bought as collateral. Thus, the Fed is inaugurating a role of "borrower of last resort" to capture excess liquidity and prevent short-term rates from drifting too far below the Fed funds target range.

In addition, several large US banks are now encouraging their corporate clients to withdraw their deposits from them and to go to money market funds for regulatory reasons. Thus, the current QE policy could have negative consequences on bank credit. In addition, more and more people are raising their voice to underline that the purchases of MBS are at least partly the origin of the extremely rapid rise in real estate prices, which would make access to property inaccessible for many. The Fed now buys about half of the MBS entering the market. Dallas Fed president Robert Kaplan believes the purchases of MBS could have adverse effects. He is probably not the only FOMC member embarrassed by these kinds of purchases. When asked why the Fed was still buying $40bn in MBS per month as house prices exploded, Board member Randal Quarles seemed annoyed and struggled to justify...

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By Bastien Drut, Chief Thematic Macro Strategist - CPR AM

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