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Inflation, GDP and What to Watch Next
The US inflation challenge is like the train wreck you can’t turn your eyes from. Of course, for us Americans, it’s also an immediate day-to-day concern so I guess the analogy should add that we are standing on the train track as well.
This comes to mind after Friday’s CPI report that inflation continues to climb. But rather than dive deep just into inflation again, I wanted to share some things I’m thinking about and watching as well. I still start with inflation since it’s freshest and central to everything…
US May CPI Numbers Show Rising Peak
Okay, the numbers were bad and worsening. Top line annual inflation (i.e., including everything) is now about 8.6%. And worse, it rose by about 1% from last month, meaning that prices overall rose another 1% over the last 30 days. If that really continues, we would have more than 12% inflation in a year.
The other reason that the 8.6% number matters is because we were hoping it might be slowing. Prices rose by 0.6% during January alone, in February prices rose another 0.8%, then March was the shocker with a 1.2% in just that month. April allowed us to catch our breath with only a 0.3% increase and that led to our hopes that maybe inflation had peaked. So the 1% increase over May sank all our hopes.
The first challenge then is that the US annual inflation rate hasn’t peaked yet and the peak may still be rising.
US May CPI Numbers Show It’s More than Energy and War
The second challenge that came from the numbers is that inflation isn’t being driven by the war in Ukraine.
Core inflation rose 6%. The Fed targets core inflation, not headline. And the Fed’s target is 2.5% plus or minus some. So 6% is way above their target.
Core inflation is inflation for everything but food and energy. If you think about it, those are the two key areas where Ukraine matters: food prices due to disruption of wheat and other products from the Ukraine (and Russia, actually) and energy due to Russian energy supplies to Europe needing to be replaced.
Food prices rose 10% and energy prices 34% over the last year. So by taking those out of the inflation calculation one would hope to see that inflation isn’t so bad. But it is. Even taking those out it’s 6%. Most of that is coming from new and used vehicles (up 12-16% in price) and transportation services (up 7%). Apparel and other items in this category look mostly to be around 5% for the year. 5% seems mild to us now and that fact alone is problematic - i.e., that we don’t think 5% sounds high. It is high. It is a problem. It’s double the Fed’s target!
Not All Prices Matter the Same Way
If apparel prices rise, you can buy less clothes or switch to cheaper brands – and there’s a lot of evidence that consumers are doing both. But if energy costs or transportation costs rise, businesses have few alternatives.
One small glimmer of good news is that transportation costs – while still high and rising 7% a year – seem to have peaked and be declining. Looking month to month again, they were rising over January by 1%, February (1.4%), March (2.0%) and peaked in April at 3.1% but dropped to only 1.3% for May. Hopefully that trend will continue as supply chains settle down, changes in shipping routes that happened due to Chinese Covid shutdowns pass as China re-opens and whatever re-routing occurred due to the Russian war in Ukraine gets finalized and settled into new patterns. It would be nice to see the supply chain and transportation problems finally subside.
All this, however, tells me that the inflation we are seeing is actual inflation and not just war or Covid (shutdown and readjustment) related. This is classical, old-school inflation. And it hurts.
If headline inflation is 8.6% and core is 6%, then core – non-food and non-energy – inflation is 70% of overall inflation and we can blame at most 30% of the current inflation problem on the war and Covid at this point. Sadly, I think we are just seeing the beginning of energy and food price inflation due to the war. Harvest season in Ukraine should be starting now. They can’t harvest and can’t ship what they do harvest. This bodes very badly for food prices in the coming 6-12 months.
Based on the latest CPI numbers, we can safely expect the Fed to continue raising interest rates at their meeting this week. 70% of the inflation is what they can “control” at all and I expect they’ll keep aiming at it by raising rates.
Unemployment and Recessions
Job numbers continue to be strong. Unemployment seems to stay around 3.6%. Nearly all the underlying numbers have remained very stable over the past months. So that is encouraging in the sense that people have jobs.
But, with real wages (your payment minus inflation) declining about 3% a year, it’s not too surprising. Declining real wages mean that workers are relatively cheap for businesses, so unemployment remains low. The downside of course is that people are working but able to buy 3% less and so they are worse off on average. That is most painful for the lowest income groups.
The fact that so many businesses are still hiring tells us that demand for their products are still strong and labor is cheap. But if that demand isn’t coming from higher wages, then it means it’s still coming from the extra money forced into the system so it’s not “real” demand, it’s “fake” in some basic way. That is consistent with stories I hear that something like 75% of American consumers say they are rapidly spending down their savings to deal with inflation. Savings ballooned during Covid when things closed and everyone got government transfers that were largely financed by printing money. So that money is still sloshing around and keeping up demand. It seems.
The Atlanta FED “nowcasts” GDP numbers. It’s just an algorithm/model that updates with each relevant data release. It’s not an official estimate, but many of us watch it.
They are now “nowcasting” around 1% GDP growth for Q2. That’s down but still positive. It has been declining with each new data release lately. So, I’m going to be very curious to see in early July where we really are in Q2 and what revisions they have for Q1. I expect a lot of revisions to Q1 numbers simply due to all the post-Covid noise, but I don’t have any expectation that the revisions will be positive or negative. I just think it’s a very noisy time so I can imagine a lot of revision will be needed.
What is more interesting to me – and something I’m watching in the news – is that markets and market participants don’t fully seem to accept the new reality yet. I still hear people comment that they don’t expect a recession or maybe next year. I still hear people comment that inflation peaked. But I look around and just don’t see it.
The Atlanta Now Cast shows the Now Cast versus the market expectations which they call the “Blue Chip Consensus”. The FED Now Case today predicts a little less than 1% GDP growth in Q2 this year. The market prediction is still almost 3%! I don’t get that. You can see it on their chart if you are curious (see footnote below).
Around the 3% “Consensus” forecast they have an upper band of the most optimistic forecasts, now around 4.5%. And the lower band of pessimistic forecasts, now around 1.8%. These are way out of bounds from the purely mechanical Fed Now Cast prediction and I just find it strange.
This is why I worry that the bubble may suddenly burst. Somewhere market participants are still a little delusional about the state of things in my opinion. I’m sure good traders can make money on this, but as an economist, I think it says the shift from “okay” to “recession” will happen fast when that mental shift suddenly occurs.
It’s kind of like a patient who sees the medical results but still can’t fathom that they have a serious illness. When they do and when it finally sinks in, it hits them hard. That’s the sort of market realization I’m worrying about.
The Rest of the World: Europe
I’ll close with a note on Europe. The UK now has about 9% inflation. The EU 8% and the European Central Bank (ECB) is raising rates and announced it will cease buying bonds for the first time in years. This will be new territory. Even with the interest rate increase they announced for July, rates will be negative in the EU. But it is clear they will rise and continue to rise.
The case for the ECB to keep on this path is even stronger than it is for the Fed. The Fed has a dual mandate of price stability (i.e., “low inflation”) and low unemployment. But the ECB’s main objective is only price stability and it has a target of 2% inflation. It’s long over due to act.
When they raise raises – even when they announce they will raise rates – we’ll see brief spikes in the value of the Euro relative to the USD, but since the US is raising rates faster than the EU and will continue to do so, the USD should continue to strengthen against the Euro on average for some time.
The challenges I’m watching for in this ECB policy shift are two. First, how will private markets, businesses, and consumers react to the new policy world of tightening rates. This is similar to my question about how US markets will react and when they’ll fully understand where they are. The EU is still behind the US in this regard, both in policy and therefore in market reaction to policy.
Second, how will the higher rates affect heavily indebted countries like Italy and Spain or even Greece and others still struggling from past debt crises. This is a challenge they are already discussing. The higher debt costs rise as rates rise and will be a problem for those economies.
In general, of course, the biggest challenge in Europe remains transitioning energy supplies, networks and processing away from Russia while also dealing with massive migration flows and new military challenges. In short, “the war”.
Those are the things I have my eye on. This week the US Fed has a policy meeting on June 14th and 15th. I think it’s predictable: we expect rates to rise by a half point again. But let’s see how markets react. As we near July and the ECB rate hikes come into play as well as final numbers on US GDP for Q2 come out, let’s see how markets react to that. If June is tough, rates rise again, and Q2 numbers are bad, then July may be the month the bubble pops on market perceptions. At least that’s what I’m wondering and watching for these days.
 For monthly numbers you can literally multiply them by 12 to see (about) what inflation would be if prices continued rising. So if they rose at the Jan rate every month inflation would be 7.2% (=.6*12), if Feb’s rate then 9.6% and so on. And also, to hit the Fed’s target of 2.5% for the year, prices should be rising about .2% per month. There’s some rounding error here, but it’s a good quick way to look at and think about these things.
 The CPI numbers are here at the Bureau of Labor Statistics. It’s a very readable report and you’ll see a table (Table A. Percent changes in CPI for All Urban Consumers (CPI-U): U.S. city average) where I’m getting the numbers from. https://www.bls.gov/news.release/cpi.nr0.htm
 Atlanta FED Nowcast: https://www.atlantafed.org/cqer/research/gdpnow?panel=3