INFLATION: ARE WE THERE YET?
April 6, 2022
Central banks, businesses, investors, and households are increasingly focused on rising inflation levels. As described by Karl Otto Pohl, former head of the German Central Bank: “Inflation is like toothpaste. Once it's out, you can hardly get it back in again.” In this report, The Mather Group, LLC (TMG) shares its perspective on inflation, identifies several drivers of inflation, and assesses the potential outlook for inflation.
Let’s begin by reviewing how inflation is measured, and who measures it. There are two primary inflation measures: the Consumer Price Index (CPI), which is calculated monthly by the Bureau of Labor Statistics, and the Personal Consumption Expenditures Index (PCE), prepared monthly by the Bureau of Economic Analysis. The CPI is the “headline” inflation measure most often reported by the media, while the PCE is the index used by the Federal Reserve Board (Fed) to guide its monetary policy decisions.
The CPI includes eight major components of consumer spending: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services. In contrast, the PCE excludes both food and energy prices, which are considered more volatile in their monthly price changes. Consequently, the PCE is often—but not always—lower than the CPI.
The February 2022 CPI was 7.9% on a year-over-year basis, which was its highest level since January 1982. Pre-COVID (2019), the annual CPI was 2.3%. The February 2022 PCE was 4.3%, which was its highest level since April 1983. Pre-COVID (2019), the annual PCE was 3.7%. As shown in the graphic below (indexed to January 2019), both the CPI and PCE have risen recently above trend.
Within the CPI, price increases in energy (up 25.6%, with gas prices rising 38.0%); used cars and trucks (up 41.2%); new vehicles (up 12.4%); food (up 7.9%); and housing (up 4.7%) contributed strongly to February’s inflation rate. The Fed estimates that, for every $10 increase in the price of crude oil, the CPI rises by 0.4%-0.5%. Excluding energy and food, the CPI was 6.4%.
Current inflation levels have at least four primary drivers. The first driver has been COVID fiscal stimulus, which has injected about $5.8 trillion into the U.S. economy since 2020, including payments to households, businesses, states, and municipalities. In addition, rent, mortgage, and student loan forbearance reduced household cash outflows significantly.
In June 2020, the Fed began monthly purchases of $80 billion of Treasuries and $40 billion of mortgage-backed securities, further increasing market liquidity. Somewhat awash in this liquidity during continuing lockdowns, households switched their spending patterns to buying goods rather than services.
The second inflationary driver has been supply chain disruptions affecting container shipments and product components such as semiconductors. The availability of desired goods fell, enabling businesses to pass through increased pricing (see used car and truck inflation, for example).
Even when business lockdowns ended, the ratio of job openings (11.3 million in February 2022) to unemployed workers (6.3 million) resulted in 1.8 openings per unemployed worker, the highest ratio in 20 years. This third inflationary driver of worker shortages has resulted in annualized wages and salaries rising 4.5% since December 2020, the fastest increase since 1983. This level is now 1.2% higher than its pre-COVID annual trend. Business have been passing these wage increases through in the pricing of their products and services.
The fourth driver has been a rapid surge in commodity prices due to recent geopolitical events in Eastern Europe. Russia and Ukraine provide 30% of the world’s wheat exports, 18% of its corn exports, 32% of its barley exports, and 75% of its sunflower oil exports. Russia is the world’s third-largest oil exporter with a 12% production share. Further, 45% of the European Union’s (EU) natural gas imports are Russian, and 60% of the EU’s thermal coal imports are also Russian. As shown in the graphic below, the uncertainty about the future availability of these basic commodities, such as oil, has driven U.S. prices above former levels.
The outlook for a positive change in each of these four drivers is strengthening. The fiscal and monetary stimulus programs that arose from the COVID pandemic are either over or winding down rapidly. The Fed is implementing a series of interest-rate increases targeting the recent rise in inflation. The sudden surge in liquidity, which began in 2020 and drove initial inflation growth, is ending.
Amid rising market fears that the Fed’s tightening may result in potential losses, the historic data shown below suggest that initial Fed hikes often result in market advancements instead. Of course, past performance is not indicative of future results.
Supply chain disruptions appear to be receding too. For example, the number of container ships waiting to unload in West Coast ports has reached its lowest level since November 2021. Semiconductor companies have announced $80 billion of new plant investment in the U.S. through 2025, although newly built plants take 1-2 years to come online. U.S. auto production was 1.49 million units in February, up from just 1.06 million last September.
With workers now increasing their labor force participation rate above February 2021 lows, and with unemployment filings falling significantly, the worker shortage is slowly decreasing. Employment levels in 2022 are forecast to be about 160 million, up from about 153 million in 2021 and about 148 million after COVID struck in 2020. In the interim, wage increases continue to rise above pre-COVID trends.
The outcome of commodity disruptions due to the war in Eastern Europe is simply unforecastable. In the next 6-12 months, many of these affected commodities may be sourced elsewhere. In the short term, an end to the war may enable sanctions to be eased and significant commodity shipments to begin again at declining prices.
What is the near-term outlook for future inflationary levels? On the qualitative side, major investment banks have offered their inflationary outlooks. Goldman Sachs, for example, predicts that the CPI will fall to 4.6% by the end of 2022 and to 2.9% by the end of 2023. The Fed, which focuses on the PCE rather than the CPI, forecasts that it will be 2.8% at the end of 2022 and will fall further to 2.2% in 2023.
On the quantitative side, the most recognized future inflation forecasting tool is the “breakeven inflation rate,” as calculated by the Fed. It simply subtracts the current yield on 5-year Treasury Inflation-Protected Securities (TIPS) from the current yield on 5-year Treasuries. It portrays market expectations of annual inflation levels during the next 5 years. Its current level of 3.29% is slightly above its former high of 2.90% reached in March 2005. The 10-year breakeven inflation rate is 2.79%, only slightly above its 2005 high of 2.76%. Given current inflation levels, both of these forecasts suggest decreasing trends in future inflation.
In summary, TMG believes there are three important points to share. First, governments, agencies, businesses, and households are acting strongly on multiple fronts to alleviate current inflationary pressures. Second, the pace of inflation’s slackening may be somewhat volatile and require some months to show demonstrable progress. Third, the commodity shortfall is being driven by geopolitical—and not economic—forces, resulting in uncertainty about the timing of its resolution.
TMG continues to employ its risk management tools in response to this inflationary trend and believes clients who adhere to their financial plan maintain the strongest pathway through this inflationary period. Your trusted advisor at TMG is ready to respond to any questions or concerns which you might have, and to help assure that your financial plan remains both timely and actionable. Please reach out to your advisor for guidance at any time.
Data Sources: Bloomberg; Bureau of Economic Analysis; Bureau of Labor Statistics; Federal Reserve Bank of St. Louis; Federal Reserve Board; Goldman Sachs; LPL Research; Pacific Maritime Commission; Semiconductor Industry Association; Statista; The White House; US Treasury; Wall Street Journal
The Mather Group, LLC (TMG) is registered under the Investment Advisers Act of 1940 as a Registered Investment Adviser with the Securities and Exchange Commission (SEC). Registration as an investment adviser does not imply a certain level of skill or training. For a detailed discussion of TMG and its investment advisory services and fees, see the firm’s Form ADV on file with the SEC at www.adviserinfo.sec.gov. The opinions expressed, and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. The opinions and advice expressed in this communication are based on TMG’s research and professional experience and are expressed as of the publishing date of this communication. All return figures and charts shown are for illustrative purposes only. TMG makes no warranty or representation, express or implied, nor does TMG accept any liability, with respect to the information and data set forth herein. TMG specifically disclaims any duty to update any of the information and data contained in this communication. The information and data in this communication does not constitute legal, tax, accounting, investment, or other professional advice. Investing involves some level of risk. Past performance does not guarantee future results.
An investor cannot invest directly in a presented index, as an investment vehicle replicating an index would be required. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown. Please feel free to contact us for additional information on any indices mentioned in this commentary.
Indexes
- Standard & Poor's (S&P) 500 - A stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States.
- Consumer Price Index (CPI) - The Consumer Price Index (CPI) is a measure calculated monthly by the Bureau of Labor Statistics that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living.
- Personal Consumption Expenditures Index (PCE) - The term personal consumption expenditures (PCEs) refers to a measure of imputed household expenditures defined for a period of time. Personal income, PCEs, and the PCE Price Index reading are released monthly in the Bureau of Economic Analysis (BEA) Personal Income and Outlays report. Personal consumption expenditures support the reporting of the PCE Price Index, which measures price changes in consumer goods and services exchanged in the U.S. economy.
