Bad News on Inflation

Chief Economist Scott Brown discusses current economic conditions.

October inflation figures were higher than expected. More troublesome, the range of items with higher inflation, relatively narrow in the spring, appears to be widening. Inflation expectations for the next five years have risen. Higher inflation is dampening consumer sentiment. The University of Michigan measures hit a decade low early November (but that doesn’t appear to be hurting household spending). Supply chain difficulties should clear up over time, but it may be a while. Longer-term inflation expectations remain moderate, reflecting the view that the Fed will act if inflation doesn’t fall back on its own.

The CPI rose 0.9% in October, boosted by a 6.1% increase in gasoline prices. Ex-food & energy, the CPI rose 0.6%, reflecting a 2.5% rise in used vehicle prices. The CPI rose 6.2% year-over-year, the highest since the first Gulf War (a year ago, the year-over-year pace was 1.1%). Restart pressures have been a key factor behind this year’s pickup in inflation. As in every recovery, it takes time for the economy to rebound. Pressures were expected to be amplified by the fact that there was a lot to come back from, and speed of the recovery was especially brisk in the first half of the year following federal fiscal stimulus and the rapid arrival of vaccines. In addition, the shift from consumer services to goods now appears to be a long-lasting phenomenon. October retail sales results will show levels far above the pre-pandemic trend. Supply chain issues are expected to continue into 2022.

Scott Brown
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The shift from services to goods explains much of this year’s increase in inflation. Inflation in consumer goods had been close to 0% (even a bit negative) over the years leading up to the pandemic. It’s sharply higher now. For services, Owner’s Equivalent Rent (OER) is a key category (it accounts for 23.6% of the overall CPI and 30.0% of the core CPI). The Bureau of Labor Statistics seeks to measure the cost of the service that a home provides, not the asset value, so considers the rental equivalent for homeowners. One sixth of the housing sample is updated each month, so it takes some time before higher rents are fully factored into the CPI. OER rose 0.44% in October, a 3.1% increase from a year ago, but a 4.6% annual rate in the last three months.

Higher wages are not driving much of the current inflation, but faster wage growth can reinforce higher price inflation. In September, 4.4 million workers quit their jobs, presumably to take a better offer elsewhere. Higher wages should lure some potential workers back into the labor force and help keep current workers from exiting. Hiring and worker retention are expected to be a major issue for firms in 2022, especially as white- collar workers can more easily work outside the traditional office. Yet. wage increases have failed to match price increases – if that continues, consumer spending growth will slow.