At his July 22, 2022, press conference, Federal Reserve (Fed) Chair Powell said that over the coming months, the Fed “will be looking for compelling evidence that inflation is moving down, consistent with inflation returning to 2%.” Is there clear, convincing, or compelling evidence that inflation is headed that way? Not yet. The outlook is still as clear as mud. Let’s look at a few factors that inform our outlook on inflation.
The level of inflation is very high. Even today’s inflation report, though down from its peak, is still uncomfortably high. As with all macroeconomic data, the markets care more about where the level is headed than where it’s been. When we think about where it’s headed, we consider the breadth and the persistence as well. The San Francisco Fed has calculated the dispersion of inflation based on the fraction of items with significant price declines and the fraction with significant price increases. In June, only 7.8% of things the typical household buys had significant price declines while 92.2% had significant price increases. That’s a lot of breadth! Breadth tends to breed future price increases.
For persistence, one way to look at it is via the Atlanta Fed’s Sticky-Price Consumer Price Index (CPI). Some prices change frequently (like gasoline prices) while others are slower to adjust (like rents). In July, the Sticky-Price CPI was up 5.8% year over year, and it’s been on an upward trajectory. The Flexible Price CPI, which doesn’t tend to tell us much about the future direction of inflation, was up 16.8% year over year, which is well off its February high of 19.8%.
So, the breadth and stickiness of inflation suggest inflation is going to stick around for a while. However, we have to consider other drivers of inflation. An easy way to think about these drivers is in terms of money supply, spending power, and supply chains.
- Money supply:
- The Fed is slowly shrinking its balance sheet, and money-supply growth (as measured by the Fed’s M2 Monetary Aggregate*) is down to 5.9% year over year, well below its February 2021 peak of 27%. For perspective, the average going back to 1960 is 7.2%.
- Spending power:
- Real spending by consumers has moderated to 1.6% year over year. The average going back to 2000 is 2.3%. So, some of the consumers’ spending spree is behind us even if there’s a continued shift in the basket of things people purchase, like shifting from buying goods back to buying services.
- With real disposable personal income down 3.2% year over year as inflation eats away at wage gains, it’s hard to see how consumer spending will reaccelerate to put upward pressure on prices, especially since the average back to 1948 is +3.4%.
- Won’t savings from stimulus checks prop up spending? Maybe. We don’t really know who saved what. Most evidence suggests that higher-income households have the excess savings, and they may be holding these as precautionary balances. We do know that as of the first quarter of 2022 (the most recent data from the Fed Flow of Funds), checkable deposits of households and nonprofits were around 3% of net worth. That’s up from 1% pre-pandemic and amounts to about $2.7 trillion in “excess savings.” While this sounds like a lot, it’s only about two months’ worth of personal consumption expenditures. If those excess savings are mostly in the accounts of higher-income households that are holding the funds as precautionary instead of transaction balances, then there aren’t really a lot of excess savings on the sideline to support spending.
- Supply chains:
- Repeated supply-chain shocks have been a recurring problem. To help quantify what’s happening, the New York Fed has a Global Supply Chain Pressure Index, which integrates transportation cost data and manufacturing indicators to provide a gauge of global supply-chain conditions. It’s a composite indicator, but the most important thing is that it was down to 1.8 in July, compared with 4.3 in December 2021. “Normal” would be zero, so there’s still a ways to go, but it does appear to be headed in the right direction for some inflation relief.
Over the next few months, this is what we expect:
- Durable goods prices will come down as supply-chain pressures ease and consumers continue to emphasize services spending over goods spending.
- Nondurable goods (mainly food and fuel) will swing wildly, but at least the average prices of gasoline and agricultural commodities have reverted back to where they were—if not lower—before Russia invaded Ukraine.
- Services prices are firm and rising, which we believe will be the source of persistent inflation in the future. Rents are the biggest component of services, but at least rent price increases appear to have slowed.
Folding these together, we expect that by September, the Fed could decide that it at least has two months of evidence that inflation is declining. Will that be enough? It won’t be enough to pause rate hikes but probably will be at least enough to slow the pace of hikes. On balance, that could be bullish for equities and bonds alike.
*The Fed’s M2 Monetary Aggregate measures the U.S. money stock that includes M1 (currency and coins held by the nonbank public, checkable deposits, and traveler’s checks) plus savings deposits (including money market deposit accounts), small time deposits under $100,000, and shares in retail money market mutual funds.
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