Prices continue to rise as demand outstrips supply across a robust economic reopening in the United States. Supply chain constraints and bottlenecks are still disrupting the flow of inputs used at earlier stages of production and intermediate goods.
We expect that inflation will peak in the fall at just under 5% on a quarterly basis and then ease back toward the Fed’s 2% target.
These disruptions underscore the imbalance between supply and demand that, in addition to comparisons to the low levels of a year ago, known as base effects, are the primary causes for the Consumer Price Index’s 5% increase on a year-ago basis reported by the Labor Department on Thursday.
We do not expect that these price increases will ease until the fall, when we expect that inflation will peak at just under 5% on a quarterly basis and then begin to ease back toward the Federal Reserve’s 2% target over the next year.
But once one looks past the top-line increase of 5%, and the core index’s gain of 3.8%, the data beneath the headlines are quite instructive.
First, energy prices are up 28.5% on a year-ago basis, gasoline is up 56.2%, and energy commodity prices rose 54.5%, all of which are behind the soaring headline number and are not sustainable. In addition, the cost of used autos is up 29.7% and transportation is 20% higher on a year-ago basis, which will also move back toward long-term equilibrium levels in the coming months.
Second, service prices remain well behaved as the economy pivots from the purchase of goods to services and vaccinations create the conditions for normal social and economic interaction. Services, which account for 61.94% of the index, increased 0.4% on a monthly basis and are up 3.1% compared to a year ago. Food and beverages, which comprise 14.95% of the index, advanced 0.3% on the month and are up 2.2% on a year-ago basis.
Moreover, our preferred reading of inflation — CPI services excluding rent and energy, which is a more pure reading of the prices of discretionary spending — increased 3.4%, which again is not exactly screaming the return of 1970s-style inflation.
If these two components, which make up more than three quarters of the Consumer Price Index, remain well behaved, the Fed’s argument that the current increase in prices will be transitory will gain traction.
It would appear that this is the case, given the lack of reaction in the bond market. The 10-year Treasury yield was trading early Thursday at 1.51%, which is hardly a signal from investors of significant risk to the outlook from inflation.
Policy considerations
While the top-line increase in inflation will command the attention of policymakers at the Federal Reserve, the underlying tone and tenor of the data will not result in any change of policy nor a pulling forward of the time in which the Fed begins to pare back its asset purchases.
Yes, prices have been increasing, but it hasn’t been calamitous.
Instead, it will elicit a round of “open-mouth operations” by various Fed members who will begin signaling the Fed’s seriousness about the price stability portion of their mandate, while not doing anything about it. The Fed will simply start laying the groundwork for the eventual change in the composition of monthly asset purchases, which include $80 billion in Treasury bonds and $40 billion in mortgage-backed securities, or the outright tapering of those purchases early next year.
Still, central bankers have to be breathing a sigh of relief because of the clearly identifiable base effects on the top-line CPI number and the well-behaved pricing data on rents. It is important to note that rents play a much bigger role in the Personal Consumption Expenditures Deflator and Core PCE Deflator, which the Fed uses to help set monetary policy.
Base effects and rising prices
There’s no doubt about it: Consumer prices are increasing. Our analysis of 41 consumer goods and services included in the Consumer Price Index shows that prices in May increased in 34 and decreased in only seven of those items.
In May as in April, increases in the price of used cars accounted for more than a third of the total monthly increase in overall prices. And gasoline prices — which have a weight of 3.6% in the overall CPI — dropped by 0.7% during the month. Apparel increased 1.2% on the month and is up 5.6% from a year ago.
By comparison, prices in April showed increases in 36 of the 41 consumer categories. (Note: the cumulative weights of those 41 items and services cover 97% of the total items tracked by the CPI.)
The headline inflation rate has already reached 5%, but is this a concern? Again, there are base-year effects to take into account for the next few months.
The inflation rate is measured as the percentage change in prices in the current month compared to the prices of 12 months ago. So the May 2021 inflation rate is relative to the lowest point of the CPI in 2020.
If you consider that the April and May 2020 inflation rates of 0.3% and 0.1% were abnormally low, then the April and May inflation rates of 4.2% and 5.0% a year later should be considered as elevated outliers.
And then consider what would have happened if the coronavirus had been contained and if the economy had not suffered an unprecedented drop in spending. We could assume that consumer prices would have continued to rise at a yearly rate of just under 2%. That was the average rate of inflation during the 12 months before the economic shutdown. (Note that 2% is considered to be a sign of normal economic growth.)
If prices had continued to rise at a 2% yearly pace during the pandemic, then the Consumer Price Index would have risen to 265 by March 2021, which is equal to the actual value of the March CPI. So yes, prices have been increasing since bottoming out in May 2020, but the increase has not been calamitous.
Still, consumers will have to deal with transitory price increases and either accept them or make other choices. As life returns to normal and as supply bottlenecks are lessened, we expect the return of normal levels of supply and demand for goods, and price stability.
For more information on how the coronavirus pandemic is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.
