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During 2021 there has been a renewed focus on inflation by the media, economists, investors, politicians and the general public alike.

Some are concerned that all the government stimulus spending and the Fed’s policy stance of low rates and a more relaxed view of inflation will lead to an unsustainable rise in inflation. Too many dollars chasing too few goods. This in turn could potentially lead to the Fed having to raise rates faster to put a lid on inflation, which could lead the economy into a recession.

The Fed and White House, among others, argue that the recent spike in April’s year-over-year CPI Index to 4.2% is due to transitory factors such as pent up demand and pandemic related supply chain issues and that a sustainable rise in inflation will not result. They believe the current policy stances and spending measures are needed to bring economic activity back to pre-pandemic levels.

Who will be proven right?  No one will know for quite some time, but the media loves this type of suspense and will use it to animate the viewer one way or the other. The April data releases on inflation gave some material to both sides of the debate.

The month-over-month change in Core CPI (i.e., CPI stripping out the more volatile food and energy components) was the largest since April 1982.

The year-over-year change in Core CPI was the largest since September 2006.

Those types of headlines lend themselves to the inflation warnings. However, the underlying causes and effects driving the headlines make it much less clear indeed and appear to support the transitory view.

From Bloomberg:

A surprise high for April’s CPI dents but does not destroy the transitory inflation thesis. Close to 60% of the month-over-month increase came from five components — used cars, rental cars, lodging, airfares, and food away from home — that will have little staying power.

Transient does not mean one month. As supply shortages run up against aftershocks from fiscal stimulus, and the base for comparison remains low, the CPI will continue to run hot into the summer. The impact of the Colonial pipeline shutdown on fuel prices will also have to be monitored closely.

The Fed has signaled that it views price pressures as temporary and is determined to look through them. Despite the surprise high in April’s CPI, Bloomberg Economics’ examination of the details suggests that view will stay intact.

The wild card would be if inflation expectations become unmoored — the next read on that will come from the University of Michigan sentiment survey due Friday. In the context of significant labor market slack, evidence of unmooring would have to be clear and significant before the Fed considers shifting its stance.

The Michigan Sentiment Survey question on expected change in price did come in high, the highest since April 2011. While the absolute level of the result is not worrying, the trend is worth keeping an eye on.

From Bespoke Investment: Three categories representing 4.7% of the total core CPI index were responsible for the vast majority of the index advance this month: hotels, auto rental, and used-autos.

Another reason for some of the high headline readings are base effects, the year-over-year measurements that look back into last year at the height of the pandemic when economic activity was halted and prices fell. Any comparisons to that period will be exaggerated.

Conclusions

Inflation has picked up, whether it is a temporary or more permanent uptick remains to be seen. As shown in the chart below, the fact that the rate of inflation has been persistently below the Fed’s stated target of 2% since the Great financial Crisis (GFC) of 2007/08 is perhaps adding fuel to the shock and awe of stronger inflation, something not seen in quite some time.

No one knows what level inflation will go to – from being okay to damaging for the economy. It is a bit like Goldilocks and the three bears, you want inflation to be not too cold nor too hot. The economy is still recovering robustly from the bottom of the pandemic, and stronger than usual inflation may accompany it for a while.  However, longer-term trends are likely to keep a lid on inflation getting truly out of hand. These include aging demographics as older generations spend less, technological innovation, which increases worker productivity and lowers labor costs, and globalization, which reduces trade barriers while bringing down costs.

 

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