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Good morning. Life of a markets journalist, late 2022. Wake up, stare at computer, ask self: anything to write about except inflation and the Federal Reserve? Answer from the News Gods: no. It’s still the biggest and, most days, most interesting story out there. If you have other ideas, send them: [email protected] and [email protected]
Inflation: probably getting better, slowly
After today’s payrolls numbers drop, the market will have to, once again, recalibrate its estimate of how much the labour market is or isn’t tightening and how the Fed will or won’t react. But remember why we care about the labour market so much right now: because of inflation. A tight labour market creates wage inflation and wage inflation is sticky and contagious — that’s the orthodoxy, anyway. What started as a goods price spike driven by tight supply chains, lockdown spending habits and stimulus cheques has turned into a surge in wage-sensitive services prices.
The job market is important. But let’s keep our eyes on the ball: what is inflation itself doing? It is easy to just shrug sadly and say “it’s high”. So it is, but the story is subtle, and continues to evolve. The details reward attention.
The first thing to say is that headline CPI has peaked. In both month-on-month and year-on-year terms, the top came in June and (at risk of tempting fate) a return to that level seems unlikely. Many commodity and transport prices are falling fast and (for what it’s worth) job listings are declining, too. There are lots of charts that look like this in circulation:
But the Fed is not going to be much impressed by these volatile, goods-driven prices in headline CPI. The focus now is squarely on core CPI — and more specifically on services such as housing, where wages are thought to be particularly important. Here is the economist Jason Furman, arguing in the Wall Street Journal this week that the Fed must not let up:
Optimists point to signs that inflation will moderate. The latest signal is the large decline in job openings, but there are also falling home prices, falling shipping costs, falling commodity prices . . . however, labour markets are still much tighter than at any point before the pandemic, and many of the other frequently cited factors have only a small or uncertain relationship to inflation. Many other signs go in the opposite direction . . . Wage inflation has picked up over the course of the year, and rent on existing leases remains well below rent on new leases.
Services inflation contains a ton of stuff, but three categories — shelter (42 per cent of core CPI), medical care (9) and transportation (8) — have dominated in recent months. This chart from Omair Sharif of Inflation Insights shows which inflation categories have driven up inflation the most since April (OER is owners’ equivalent rent, or what homeowners would rent their house out for):
Start with transportation services. Look beneath the hood and you quickly spot the bit that’s on fire: airfares. Since the pandemic, plane ticket prices have been exceptionally volatile.
This isn’t terribly shocking given pandemic disruptions to travel and fuel prices, but with the Omicron coronavirus variant hit to travel well behind us, we’re surprised how volatile airfares have remained. A slowing economy is cutting air travel demand, but the holiday season will boost it. Alan Detmeister, an economist at UBS, figures airfares, and transportation services inflation, won’t fall consistently until next year.
Medical care services are more interesting. As we’ve written, prices here hinge on insurance company earnings data that is updated once yearly, and on a long lag. As a result, Detmeister points out, every CPI report published so far this year has been based on price data comparing 2020 to 2019. When new data comes in October’s CPI report, all the analysts we talked to expect medical services will get squashed, dragging down core services.
You’ll notice that neither of these two categories really contains the usual story about wages or a tight labour market. As Sharif put it to us:
I just see people blindly looking generally at core services, seeing how high it is, and saying, ‘Oh, this is obviously a function of wage growth’ . . . What will people be saying in three months’ time when medical care becomes a drag on core services and transportation isn’t showing 14-15 per cent in airfares?
The last category, shelter, is inflation’s key link to a tight labour market. You can observe that empirically, but the intuition is plain enough. Here’s Detmeister again (notice that he emphasises stable employment over wages):
If you get a job, and a stable job, then you’re more willing to move out of a group house to have your own place. You’re more willing to move out from living with your parents. So [shelter inflation] is more tightly linked with the unemployment rate than with wage growth itself.
We’ve long known shelter inflation would come in hot this year, but it’s becoming clear that the peak is due soon (if it hasn’t come already). CPI’s shelter components are based on rental data. And private market rent indices kept by websites such as Zillow and Apartment List have been decelerating:
Remember that what makes an inflation rate go up is not whether rents are increasing, but whether they are accelerating. So for this index, the tip of the hump above should represent peak rent inflation.
Of course, the Zillow index is not an exact apples-to-apples comparison. It measures newly signed leases, while CPI rent indices captures the full universe of new and existing leases. But it does offer a look into the future. CPI rent tends to follow the private indices on a lag, the median of which is eight months, according to Nomura’s Aichi Amemiya. That pattern, he says, suggests month-on-month rent inflation should start falling around January, though gradually.
The point is that while the jobs market-inflation story matters, current data suggest the worst has passed. Put together, we have a picture of services inflation that will moderate, slowly, as airfares eventually settle, new data deflate medical care and CPI rent indices catch up with current conditions.
For markets, the optimistic bit is that a cataclysmic wage-price spiral looks unlikely. But avoiding disaster doesn’t mean inflation’s grinding descent will be pleasant. We’d guess that there won’t be enough good inflation news to knock the Fed off its march to 4-5 per cent rates. In the meantime, plenty else could go wrong. (Ethan Wu)
One good read
Are the current disruptions the birth pangs of a new economic regime? Or just a temporary interruption of the old one? Our bet is on the latter. The Economist has put its chips on the former.
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