Inflation Slowdown to Accelerate After Q1

Summary

• Consensus forecasts see end-2022 YoY core PCE at 3.6% against 2.6% in the FOMC December SEP. I think the Fed is more likely than consensus to be right for the following reasons:
  • Though likely to pause in Q1, the switch from goods to services consumption has finally started and could trigger a disinflationary chain reaction with inventories demand and logistics. 
  • Services inflation could slow alongside falling wage growth as labour market slack is likely to trough in Q1.
• Given currently high inflation and low unemployment, the Fed will likely remain hawkish in Q1-Q3.  Only in Q4 will the dovish pivot take place. 

Market Implications

• Curve flattening in Q1-Q3 followed by curve steepening in Q4.

The Goods to Services Consumption Switch Is Just Beginning

The 2021 acceleration in inflation largely reflects goods prices. Goods price inflation has remained high despite US and global industrial production perking up in early Q4 (though the recovery has paused in December likely due to Omicron). The supply recovery will likely continue as more countries have accepted that Covid is endemic and that risk mitigation strategies are more sustainable than lockdowns.

The persistence of high goods price inflation reflects that the switch from goods to services consumption only started in late 2021 (Chart 1).

The recent winter surge in Covid cases has likely paused the switch, but it should resume this month or next as the surge continues to recede.

Falling consumer demand for goods will likely trigger a chain reaction. First will be with inventories, then eventually logistics. Inventories-to-sales ratios are rising, even in auto retail. With a continued decline in goods consumption, inventories demand will likely ease.  Lower demand for goods will eventually cut logistics bottlenecks, which already started to improve at end 2021.

Simultaneously, services inflation is also likely to slow.

Services Inflation to Slow as Labour Market Slack Will Trough

Services inflation tends to be strongly correlated with nominal wages, which is hardly surprising since labour is services’ main input. Wages in turn reflect labour market slack. I think the labour market slack is about to trough in Q1 for two broad reasons. First, GDP growth is likely to slow from here as:

• GDP growth is returning to trend. 
• Fiscal policy has turned contractionary.
• The household savings rate has stabilized which leaves consumption dependent on real household income that has already started to contract.

The bottom line is that the fiscal and monetary stimulus of 2020-21 was so large that normalizing fiscal and monetary policy without a hard landing will be very difficult.

Second, as the economic slowdown starts, the labour market could prove much less resilient than consensus expects because, since the start of the pandemic, the number of actual hires relative to advertised vacancies has collapsed. That is, firms are advertising positions but are unwilling or unable to offer high enough wages to fill them. ‘Excess’ demand is therefore likely to disappear much faster than consensus expects once the GDP growth slowdown gains momentum.

Inflation Has Already Started to Slow

Inflation has already started to slow. This is unobvious because supply shocks have raised inflation volatility, which has made reading the trend harder. Trimmed mean inflation, whether PCE or CPI based, shows a sequential slowdown. Even core inflation is slowing when averaged over six months (which strips out some of the volatility), core PCE and CPI also show a sequential decline.

In December, six-month annualized core PCE was 3.7% against 4.9% YoY. So, if MoM core PCE remained at the average of the past six months throughout 2022, we would get a slowdown close to Bloomberg consensus expectations of 3.6%. That is, the consensus assumes that 2022 disinflation will reflect mainly base effects. By contrast, the 2.6% end-2022 inflation the Fed expects aligns with a monthly 2bp decline in MoM inflation, the average monthly decline in the six-month average since August. The above analysis suggests inflation is likely to end 2022 closer to the Fed’s than the consensus view.

Market Consequences

With YoY PCE at 5.8% and the Fed Funds Rate at 0.1%, the Fed is likely to remain hawkish until the data clearly establishes that substantial disinflation is underway.   A hawkish Fed against a background of disinflation suggests curve flattening.  By contrast, a switch from hawkishness to dovishness in Q4 could lead to curve steepening.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

(The commentary contained in the presentation does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs)