Consumer prices keep surprising on the upside as the US economy reopens. Excluding food and energy, May’s consumer price index (CPI) rose sharply by 0.7% after already surging 0.9% in April. Thus, core inflation jumped from 3.0% to 3.8% reaching its highest levels since 1992 as the chart shows and running well above the Federal Reserve’s 2% target.
The central bank, however, is still unlikely to react by tapering its quantitative easing this year, preferring to wait instead until early next year when the labour market has recovered further.
First, the bulk of May’s consumer price gains continue to be driven by temporary shortages of goods and reopening demand for services. Second-hand car prices surged by 7.3% last month after already rising 10.0% in April and new car prices increased by 1.6% as vehicle production remains constrained by the current shortage of semiconductor chips globally. Similarly, airfares jumped by another 7.0% last month having also surged by more than 10.0% in April as demand for services returns.
The sharp ‘cyclical’ rises here reflect demand outstripping supply as the economy reopens. But over the next few months, inflation should ease as goods shortages are resolved and service activity settles again at pre-pandemic levels.
Second, more persistent ‘structural’ sources of inflation remain tamer.
Source: Bank of Singapore, Bloomberg
Sheltering costs - that account for a third of total US consumer prices - are starting to firm as the economy recovers and rising house prices support rents. In May, owners’ equivalent rent increased by 0.3%, pushing its YoY inflation rate up to 2.1% as the chart shows. But other long-term drivers of inflation remain subdued. Last month, health care costs dipped 0.1%. The Fed’s target measure of inflation - personal consumption expenditures (PCE) - may increase less than CPI, likely rising from 3.1% to 3.3% in May.
Third, Fed officials will be heartened that financial markets remain calm despite sharp near-term increases in inflation. After May’s CPI report was released, the USD remained soft with the EUR still trading close to 1.22, the S&P 500 rallied to a new record high of 4,239 and 10Y Treasury yields fell to 1.43%, sharply down on their 2021 high of 1.77% hit at the end of March. Financial markets are siding with the Fed that summer increases in inflation are still likely to be temporary only.
Last, inflation expectations remain anchored around the Fed’s 2% target. 10Y breakeven rates are currently at 2.35%, down from 2.60% in May.
Thus, the Fed is likely to stay cool about the current surge in inflation. We expect officials will discuss tapering at their June meeting next week - and keep talking for several months to give plenty of warning and thus avoid a taper tantrum this year - but only announce in December that the Fed will slow its bond buying in early 2022.Disclaimer applicable to recommendation
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