Highlights
America’s reopening is pushing inflation well above the Federal Reserve’s 2% target. April’s consumer price index (CPI) surged by 0.9%MoM - when excluding food and energy - raising core CPI inflation from 1.6% to 3.0%YoY. In addition, the CPI data make it highly likely that the Fed’s target measure of inflation - changes in core personal consumption expenditure (PCE) prices - will also jump from 1.8% in March to around 2.8% when April’s PCE data is released on May 28.
The Fed, however, remains firmly dovish giving no signal it will taper its quantitative easing nor lift its fed funds rate from 0.00-0.25% as it sees increases in inflation above its 2% target being only temporary as the economy reopens. So far, consumer price rises do seem largely transitory - in line with the Fed’s view that inflation will settle down again as supply catches up with demand.
First, good prices are surging because of temporary shortages. In April’s CPI report, second-hand car prices jumped by a record 10.0%MoM as scarce semiconductors reduced the production of new vehicles globally. But as the shortage of chips eases over 2021, car output will rebound again reducing pressure on prices.
Second, the prices of services are also spiking as demand rebounds with the economy reopening. Last month, hotel and other lodging costs rose by 7.6%MoM and air fares by 10.2%MoM. Once activity returns to more normal, pre-crisis levels, however, demand for services will stop surging.
Source: Bank of Singapore, Bloomberg
Third, scarce labour appears to be holding back production and thus increasing prices. But as the pandemic wanes, unemployment benefit top-ups finish and schools reopen in September, the current shortages of workers should also improve.
Thus, near term increases in inflation seems to be largely ‘cyclical’. Consumer prices seem set to stabilize again once the economy has fully reopened and core PCE inflation should peak near 3% in May and June. The Fed will therefore give core inflation several months to start falling back to its 2% goal rather than suddenly turn hawkish over the summer.
The risks to the Fed’s dovish stance come from more ‘structural’ drivers of inflation. If workers remain reluctant to return even as the pandemic eases then wages will heat up. If the decade-long rise in US house prices accelerates then it may spill over into higher rents; or if this summer’s shortages of goods and services boosts inflation expectations well above the Fed’s 2% goal - as the chart shows is already occurring - then inflation rises may become entrenched above 2%. But over the next few months the Fed remains willing to allow inflation to exceed its 2% target to see if price rises do turn out to be only transitory.
Financial markets thus face a long summer of inflation risks. But if the Fed is proved right and inflation peaks - as we expect in May and June - then risk assets will stay supported as the central bank will not taper quantitative easing this year.
