Powell Calls Time on ‘Transitory’: Authers’ Indicators

The 6.2% headline level of October consumer price inflation was higher than anyone had expected, and quashed debate over whether this is a serious problem. The Fed’s preferred measure of inflation, the core personal consumption expenditure, or PCE, deflator, remains at its highest level since 1991 and is still increasing. Producer price inflation, as 12.1%, is running at the highest level in four decades. But most important was the lesser known  “trimmed mean” measure, which excludes goods that have suffered the most extreme changes in price in both directions, and is held to be a good indicator of the breadth of inflationary pressure. At 4.1% for October, it is now looking more extreme than any of the headline measures, and is more than five standard deviations above the norm for the last decade.

There is deepening concern over rental inflation, the single biggest component of the CPI index, which is now up to 3.1%—and still slightly below its average for the last decade. It’s likely to rise further as higher house prices pull up rents in their wake.The most extreme transitory effects of the pandemic are otherwise beginning to ease. Car rental prices, for example, are now “only” 39% higher than they were 12 months ago, having topped 100%. Meanwhile, several sectors that suffered a deflationary blow from the pandemic are still not seeing prices recover. Inflation in drug prices is still negative, and prices are no higher than they were four years ago.. And earlier this year  — heaven be praised — college-tuition inflation dropped to its lowest since records began in 1979, at 0.2% — although it has since ticked back up to 1.8%. While the rise in prices has broadened, there are still some pockets of the economy where the pandemic appears to have reduced inflation to defensible levels.

After much excitement in recent weeks, the picture portrayed by the bond markets is surprisingly very positive—from the point of view of those who don’t want to see inflation return.   They see inflation staying high over the next five years (although the five-year breakeven has now dipped back below 3% having set a record high since five-year inflation-linked bonds were introduced in 2002), but then moderating significantly. The five-year/five-year breakeven, covering average inflation between 2026 and 2031, has declined slightly in recent weeks and is now slightly below its average for the last decade. Meanwhile, the yield curve has flattened dramatically, suggesting a belief that central banks will hike rates too much in the short run, and that inflation will be tamed thereafter. The yield curve is also now flatter than it has been on average for the last 10 years.

While markets plainly believe inflation will be well above the Fed’s target for the next few years, therefore, they are still positioned for the central bank to regain control. They do not anticipate accelerating inflation from here. The one intriguing development is that investors are bidding up the possibility of higher inflation in Germany, an economy that has been in deflationary conditions for a decade.

These numbers offer the greatest support for the case that inflation is a near and present danger. All are way above their ranges for the last decade. The small-business survey shows inflation expectations at their highest in four decades, while the Institute for Supply Management numbers for both services and manufacturing hit post-crisis highs earlier this year, and are still at levels barely seen since the early 1970s. These problems are driven by supply bottlenecks, and it isn’t clear that the peak is in. Consumer expectations have also risen very sharply, to their highest since the commodity price spike before the financial crisis, with the latest surveys of one-year expectations from the Conference Board and the University of Michigan both showing a new high for the cycle, while broader consumer confidence declines severely. This could be transitory, and expectations for inflation five years hence are much lower. But expectations so high do raise the risk that inflationary psychology becomes embedded.

Rising commodity prices represent exactly the kind of inflation that can attack living standards. But, given the economic collapse a year ago and the rush by speculators to get a leveraged play on the rebound, they don’t give firm evidence of inflation that is more than transitory. At one point, the Bloomberg Industrial Metals index had more than doubled since its Covid-19 bottom in March last year — but it has given up 12% since its peak in October. Energy prices also more than doubled from their Covid shutdown low, but always remained below their average for the last decade and have shed 23% since their October peak. An unwelcome development in the last few weeks is another surge in lumber prices, although they still remain far below their levels from earlier this year. Perhaps the most ominous sign comes from the Commodities Research Board raw industrials index, which covers basic commodities that aren’t in the futures market. In theory, these prices should be driven by supply-and-demand dynamics, and so the 57% rise since last year’s low, to set a new all-time high at which it now appears to have stabilized, should be taken as a “tell” that genuine cost pressures are building for industry.

Wage rises are picking up noticeably—but it’s not yet clear that wage expectations have become untethered from the generally muted conditions of the last decade. The latest figure for average hourly earnings growth, at 4.8%, is above its average for the past 10 years, but represents a slackening of the pace since October. However, there may be compositional effects involved, as the lowest-paid workers tend to be the first let go at the sign of returning problems with the pandemic. Job vacancies are at an all-time record, while small businesses complain that they have never found it harder to recruit workers. This suggests a problem with skill mismatches coming out of the recession. The wage tracker kept by the Atlanta Fed shows wage inflation for low-skilled workers at 3.7%, its highest level since the global financial crisis, and for the fifth month in a row higher than wage inflation for the higher-skilled. This is the first time that wage rises for the low-skilled have outpaced wages for the higher-skilled for so long, suggesting that major changes are afoot in the labor market as it tries to return to normal after the pandemic. Wage rises for the high-skilled are barely above the norm. The National Federation of Independent Business found in September that the highest proportion of its members were raising pay since it started asking the question in 1984.

Broadly, the consensus is that the Fed, like other central banks, will get what it wants. Among economists judged collectively, this belief has been unwavering for months. The Fed is forecasting core PCE of 3% for this year but expects it to decline to 2% in 2023; in other words, it will be transitory. The experts are less anxious for now and think it will reach 2.5% this year and decline in the two following years — more or less perfect for the Fed, which is prepared to let inflation “run hot.” German inflation, after a bobble this year, is expected to fall back to 1.7% in 2023; there’s no sign of a new reflationary cycle there or in Japan, or even China. Whatever markets say, the experts are still more worried about deflation. These measures don’t change much — if the experts ever do get a little nervous, take note.