CPI to Fall Well Below the Fed’s 2% Target by Mid-2022

Summary

• The recent drop in yields likely reflects market reassessment of US growth and inflation prospects.
• This is consistent with my detailed inflation scenario showing inflation will likely be below the Fed’s 2% target by mid-2022.
• There is a risk the Fed could taper in September, which would see the curve flatten further but have limited impact on the real economy.

Market Implications

• Flatter curve

Higher Inflation Is transitory, But Cutting Into Household Incomes

I believe the recent drop in yields, including on the curve’s short end, reflects sliding growth and inflation prospects. In this note, I build a detailed inflation scenario showing that even with persistent demand and supply imbalances, inflation will likely significantly undershoot the Fed’s 2% target by mid-2022 (Chart 1). In doing so, I have accounted for both supply and demand factors.

That inflation spiked following the stimulus checks to households is no coincidence. The administration’s American Rescue Plan (ARP) was more a large stimulus likely intended to run the economy hot than a COVID relief package. If so, the ARP fulfilled its objectives beyond the administration’s wildest wishes.

Yet I believe inflation will prove unsustainable. The ongoing inflation spike has led to a fall in real wages and real labour income (wages times employment): in May, real labour income was still 2% lower than in February 2020. Meanwhile, 33 states have already stopped pandemic unemployment benefits, further cutting household income. In a consumption-driven economy, lower household income means lower growth. Lower growth in turn will weaken firms’ price power and help stabilize inflation.

Supply and Demand for Cars Will Normalize and Prices Fall

Because the CPI is released ahead of the PCE, I have focused on the former. I divided core goods prices between transportation and other goods, since cars and trucks have been the main source of goods price inflation. Based on industry reports, I assumed car supply would start improving in the summer and return to normal in Q2 2022. I also assumed that once the supply situation normalizes, prices will fall – by more with used than new cars as the premium of new relative to used cars will likely revert to trend.

I further assumed that outside of vehicles, starting in January 2022, core goods prices would flatten out . This is because I expect supply chains and global transportation costs to normalize and demand to slow. Goods consumption is falling as households rebalance between goods and services: there is a risk of a goods recession . Regardless, flat goods prices would align with pre-crisis trends. That is conservative if anything s in reality core goods prices have tended to deflate.

Core Services Will Return to Pre-Pandemic Trends

The CPI weight of core services is 2.5 times larger than that of core goods. Within core services, rent of shelter, driven by owners’ equivalent rent (OER), accounts for over half the weight. As previously discussed, I do not expect the end of the eviction moratoriums to pressure rents. Also, OER has historically been driven much more by labour income than house prices. I therefore built a rent scenario based on a steady but gradual recovery in labour income.

I also computed a detailed estimate of the cost of transportation services. In insurance and public transportation, prices are currently below pre-pandemic levels. I have assumed that over the remainder of 2021, prices recover to pre-pandemic levels and in 2022 grow around 2.5% a year. This reflects that public transportation capacity is intact: airplanes, ships, and trains have been idled and could easily be put back in service.

For medical care costs, I have assumed hospital costs continue growing at the current pace and medical professionals see an increase in insurance payments at end-2021 similar to that at end-2020. I have also assumed the cost of health insurance continues to fall, following a 50% increase in 2020, which reflects how the cost of health insurance is inputted in the CPI rather than actual premiums paid.

Services prices returning to pre-pandemic trends would also be consistent with the strong productivity growth that the pandemic has elicited. With limited workers’ bargaining power, productivity growth will more likely translate into constant prices or higher profits than with higher wages.

Market Consequences

While inflation is likely transitory, the increase in the price level is more than I and most market participants expected (which likely reflects ARP’s scale and lack of targeting). It seems to have also surprised the Fed and elicited a hawkish turn that could see further curve flattening.