The outlook for the American economy is increasingly at risk as the consumer piece index rose at an annual rate of 3.8% in April, driven by the war in Iran and the supply shock that it triggered.
With no end in sight to the war and the effective closure of the Strait of Hormuz, the primary catalysts for rising inflation—energy, oil, gasoline, transportation and food—are all poised to rise in the coming months as global supplies grow tight and supply chain stress rises. In April, the top-line CPI rose by 0.6% following the 0.9% increase in March.
This is why stagflation lite remains the economic baseline with the primary risk being inflation and not necessarily slower growth.
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The higher prices extended beyond those areas affected by the supply shock. Core CPI, which excludes the more volatile food and energy components, increased by 0.4% on the month and by 2.8% annually not only because of a statistical quirk at the Bureau of Labor Statistics but also because of a large 0.6% monthly increase in services, which rose by 3.4% on the year.
That surge in services pricing was not a result of last year’s government shutdown; instead, it was part of a persistent inflation challenge that suggests the possibility of a shift upward in the American inflation regime.
Just as important, American consumers are facing a threshold moment as they experience a mild decline of 0.3% in real wage growth, which adjusts for inflation.
Our forecast is for inflation to peak at or above 4.5%. If nominal wage growth continues at a pace near 3.5%, such an increase would imply a 1% decline in real wages in the near term which will dampen overall spending and growth.
It is why back in April we revised down our forecast for gross domestic product this year from 2.4% to 1.7% with risk of further deterioration the longer the conflict endures.
At this point, we are less worried about the economic outlook than we are about a new inflation regime that may be higher than the 3% before the outbreak of the war.
It has been more than five years since inflation was at the Federal Reserve’s 2% target.
Underlying inflation dynamics and the real possibility of a multiyear period of higher oil and refined product prices out of the Middle East because of long-term damage in production capacity should be front and center in driving policy and investment decisions.
Policy implications
What might have been a difficult decision for the Federal Reserve in June on whether to cut the federal funds rate or keep it in a range between 3.5% and 3.75% has now turned into two-sided risk to the Fed’s dual mandate of maintaining stable prices and fostering full employment. The central bank may need to hike rates should the war linger into the second half of the year.
Because we have a good sense that the May pricing data will send top-line inflation above 4%, it is highly likely that the rate cut bias currently embedded in the Fed’s policy statement will be removed at its June meeting to create space for the central bank to hike rates, if necessary, this summer.
This one reason why the long end of the Treasury yield curve is resetting higher with the 10-year yield testing 4.5% once again and the 30-year yield at 5% and poised to move higher.
Given the upward pressure on prices, it is simply not appropriate to consider rate cuts as Kevin Warsh takes the helm of the Fed this week.
Warsh is inheriting a historic supply shock that monetary policy is neither designed nor well positioned to respond to, yet monetary policy will get blamed should inflation move higher or the economy slow on the back of negative wages and demand destruction.
The truth is that fiscal policy is the solution to supply shocks.
Geopolitical security judgments, trade, tariffs and fiscal prudence are not within the province of the Fed yet are those channels that will shape the direction of the economy.
The data
As expected, it was the energy complex that was the primary driver of inflation in April. Energy increased by 3.8%, energy commodities rose by 5.6% and gasoline costs by 5.6%. A year ago, they were up by 17.9%, 29.2% and 28.4%, respectively.
From our vantage point, it is the service sector increase of 0.6% in Apri and the move higher of 3.4% over the past year that is the longer-term challenge.
With an economy that continues to grow at or near trend bolstered by an equity market tailwind and fiscal accommodation, demand for services remains strong and this is what is driving core inflation higher.
Inside the much talked about housing sector data, prices were up by 0.7% overall, shelter advanced by 0.6% and the policy sensitive owners’ equivalent rent series increased by 0.5%.
While those will adjust downward next month, they are still too high for central bankers to consider rate cuts.
Transportation costs surged in April. The airline fares index jumped by 2.8% on the month and by 20.7% over the past year while new vehicles dropped by 0.2% and used cars and trucks were flat on the month.
We have argued that the rising price of diesel would be passed along to households in terms of higher grocery prices. As such, food costs increased by 0.5% monthly and were up by 3.2% annually and are poised to move higher even if the war ends soon. The data showed several large monthly increases in a variety of food prices.
Apparel costs increased by 0.6% and were up by 4.2% from a year ago while the medical care index fell by 0.1% on the month while rising by 2.5% over the past year.
The takeaway
The U.S. economy is absorbing the first round of the supply shock as anticipated. But the economy may be stepping into a new inflation regime that features 4% price increases that will define at the very least the second half of the year.
Currently we see only a 30% probability of a recession this year as a dynamic tech sector, rising equity prices and a fiscal tailwind are cushioning the exogenous shock in pricing of energy.
Unless war results in a broader destruction of oil and refining capacity in the Middle East, which would further curtail supplies, we do not see the American economy falling into recession.
Still, rising prices of oil, gasoline and diesel are pushing up transportation costs that are causing a jump in food prices.
The onset of declining real wage growth should be closely monitored given the sour condition of consumer sentiment.
Underlying inflation conditions because of oil and gasoline prices imply a north of 4% in inflation in the May CPI reading.
These inflation dynamics are creating policy conditions that will surely result in a change in the rate bias at the Fed and keep the central bank on the sideline in the near term. If anything, pricing dynamics will stimulate talk of rate hikes rather than rate cuts as we head into the second half of the year.
