Will there be a break in inflation?
“Another month, another dashed dream of peak inflation. And while there is room for a bit of optimism that is getting lost in the renewed panic over prices, it isn’t enough to change the inflation problem dominating the economy and politics.
Data released Friday by the Department of Labor showed that the consumer price index rose 8.6% in May from a year earlier, a fresh 40-year high as the price of almost everything increased. That is as Wall Street expected a slowdown, if slight, from April’s 8.3% pace. The Biden administration had some investors braced for another hot report after press secretary Karine Jean-Pierre said during the week that headline CPI would be elevated while surging energy prices—backed out of core inflation figures—would bleed through to things like airfare. But the report was still bad enough to sink stocks and convince traders that the Federal Reserve has no choice but to lift rates by at least 0.5% at each of its next three meetings through September.
The worse-than-expected report shouldn’t be a total shock. This column has been writing that peak-inflation calls were premature given what is going on in energy, food, and shelter markets. Consider the Barron’s Basics CPI, comprising year-over-year changes in foods like meat, eggs, bread, milk, and produce, in addition to shelter, gas, and utilities. It jumped 17% in May from a year earlier and 2.5% from a month earlier. The prices of essentials with relatively inelastic demand, which monetary policy can do little to cool, are still flying—and the war in Ukraine threatens to push food and energy prices higher still.
What is more surprising is the lack of inflation relief on the goods side of the economy. The expectation that consumers would shift demand to services from goods, where supply shortages have been acute, finally seemed to have started to play out. Consider the message from Target TGT –3.06% (ticker: TGT). The retailer earlier in the week cut its earnings guidance for the second time in three weeks, warning that profit would decline as it slashes prices to clear unwanted inventory. The company had earlier reported a 43% rise in inventory during the latest quarter and said more-expensive basics mean customers are cutting discretionary spending.
Yet the May CPI report showed virtually no relief in goods prices. Here is where there is some good news. Consumers are starting to catch a break, though it is obfuscated by a timing mismatch between what some retailers are reporting and month-old CPI data. As economist Oren Klachkin at Oxford Economics puts it, the May inflation data show us what has already happened, while the Target warning shows us what is to come. The latest wholesale inventories report shows the inventory-to-sales ratio remains well below the prepandemic average, and Peter Boockvar, chief investment officer at Bleakley Advisory Group, says it will take a few months for retailers’ price cuts to cycle into the data.
That is where the good news ends. As Boockvar points out, core goods represent only 20% of the CPI. And while retailers like Target and Walmart WMT –1.16% (WMT) are overstocked and seeing discretionary demand wane, Boockvar notes that Nordstrom JWN –6.36% (JWN) is selling more back-to-work and vacation apparel. The point: Goods disinflation, on net, will be moderate and is no panacea.
The bigger problem with the break in some goods prices is that it is simply not the right break. What will continue to matter most for many households and businesses are the items economists and policy makers exclude from their favored inflation gauges, on the grounds that food and energy prices are volatile. But now inflation in those categories is persistent and taking a greater share of households’ spending as inflation-adjusted wages are falling. Richard Farr, chief market strategist at Merion Capital Group, notes that when you adjust the average hourly earnings data reported in this past week’s jobs report with the latest CPI data, you see that real average hourly earnings fell for the eighth straight month in May and by 3% from a year earlier.
Omair Sharif, president of Inflation Insights, notes that gasoline prices still aren’t at their peak when you adjust for inflation. Still, he says, the shock over the past four months has been staggering. He says the jump in the share of spending on gas since early 2022 is the biggest four-month increase since the data began in 1959, and his math suggests households’ share of spending on gasoline will jump to 3.2% in June—the highest in eight years and above the long-run average.
The actual impact of energy prices is much bigger than the outright share of household spending on gas would suggest. Energy is what matters most for the consumer, says Farr. “If your base case on inflation peaking is that you just got a discount on some cheap T-shirt at Target, you may want to look a little deeper because oil goes into everything,” he says. “Every item needs petroleum to be shipped.” That especially applies to food. In the U.S., transport and packaging represent the biggest portions of overall food costs.
Even as goods disinflation starts to kick in, Farr says there is another reason to expect higher overall inflation. The lag in owner-equivalent rent—the way the government turns housing into a service for the purpose of calculating the CPI—versus home prices means inflation may be understated for up to two years, he says, pointing to research from the Federal Reserve Bank of Dallas that predicts rental inflation rising at a 6.9% year-over-year rate by December 2023. In May, rental of shelter rose 5.5% from a month earlier.
Recent data from John Burns Real Estate Consulting show that cash buyers are taking a bigger share of home purchases as mortgage rates rise. CEO John Burns says that slice rose to 22% in April, up from 18% at the start of the year. That data point highlights how hard it is going to be to cool home prices this tightening cycle, another reason overall inflation will remain stubbornly high. Merion’s Farr, for his part, says the Dallas Fed’s rent inflation estimate is probably too low.
The bottom line is that some inflation relief is coming, and any break will be welcome. But where relief is most needed will remain elusive, with policy makers and politicians unable to do much in the immediate term to alleviate the pain consumers are feeling and change the narrative around inflation.”