US headline CPI inflation is currently running at 5% and many, including the Fed, are fearing the return of high inflation. Markets are also concerned, especially in the near term. US inflation-linked markets are pricing 3% inflation for the next two years, but a lower 2.5% for the next 10. Meanwhile, the consensus of economists expects inflation of above 3% at least until Q1 of next year, before a moderation to 2%.
A challenge for investors is to strip base effects and temporary supply constraints from more enduring drivers of inflation. After all, a year ago, US inflation had fallen to 0.1% and many, including the Fed, feared ongoing deflation. So current high prints do not necessarily mean there will be strong negative base effects for inflation next year.
One way to look at this is to project recent CPI trends into next year and then calculate likely CPI prints. We consider three trends: 2010 onwards when headline inflation was averaging around 1.8%; 2016 onwards when inflation was averaging 2%; and we construct a new trend from the pandemic period of April 2020 onwards, assuming inflation is at a new 3% trend (Chart 1).
We find that if the CPI reverts to the 2010s trend, headline inflation for the May 2022 print would fall to -1.4% – which shows a strong negative base effect. With the 2016 trend, we find inflation would fall to +0.4%. Finally, with a new 3% pandemic trend, inflation would fall to 1.5%.
Therefore, even with a more aggressive assumption on the CPI trends, headline inflation prints may struggle to stay above 2% in a year. At worst, we could see deflation. The main lesson is to be wary of reading too much into recent high prints of inflation. If anything, the risks for subpar inflation in 2022 have likely increased.