Lessons From Last Week

Too Soon For All-Clear!

The US Federal Reserve as well as consumers got a burst of welcome news. Figures released Wednesday by the US Bureau of Labor Statistics indicated that US consumer prices rose by only 2.97% in June compared with June 2022, a notable deceleration from the 4.05% year-on-year increase in May. Could it be that the Fed’s 16-month long anti-inflation effort is finally succeeding? US equity indexes took a victory march in response.

More good news came on Thursday with the Producer Price Index rising by only 0.1% in the year ending June. The month-on-month rise was just 0.1%, reversing a 0.4% drop in May. Core PPI, excluding food, fuel and trade services, was up 2.6% over the past year, slowing from 2.8% in May.

There is no gainsaying the positive nature of the numbers. The annual consumer price inflation number has a 2-handle on it, compared with the central bank’s target of 2%. My response, however, is to counsel more caution than what was reflected in risk assets’ performance. First, the number refers to the headline rate which includes two volatile components, food and fuel. By comparison, core consumer prices, which exclude the two factors, rose by 4.8% over the past year — down from 5.3% in May but still over two times the Fed target.

Second, recall that the June 2022 inflation rate of 9.1% was the highest for any month since mid-1981. When compared with a month with an extremely elevated inflation rate, price increases look more benign than they actually are — a circumstance that statisticians refer to as the “base effect”. As monthly inflation rates were lower starting in July 2022, it is worth waiting to see if the improvement persists.

Third, the headline inflation rate last month of 2.97% was influenced significantly by the decline in the cost of fuel over the past year. This is unlikely to be repeated to the same extent during coming months, or the trend could even be reversed if the OPEC Plus group of countries (OPEC plus Russia) successfully reduce oil production in response to the fall in global demand. The risk of re-acceleration of core inflation is demonstrated by statistics over the past year. After reaching a low of 5.9% in June and July 2022 compared with earlier months, core inflation jumped to 6.6% last September, and remained elevated in subsequent months.

Stamping out inflation has been compared to playing whack-a-mole. When services — e.g., hotel and restaurants, air travel — were hit during the early days of covid, consumer demand switched to goods which experienced rapid price increases. Since then, services, especially rents, became a major contributor to price rises. While this component is slowing, further progress may be limited by the surge in home prices, pushing more potential buyers into the rental market.

Also providing evidence of the whack-a-mole nature of inflation across sectors, the cost of services other than energy rose by 6.2% in June over the past year, remaining a major contributor to overall price increases. The increased cost of services is a reflection of the 4.35% increase in average hourly earnings over the past year. The strong labor market, and growth in earnings, are incompatible with lowering inflation much further.

Rapid price increases switching from sector to sector over the past three years is explained by the substantial stimulus provided in the early months of the Biden administration. The Fed, under the leadership of Chairman Jerome Powell, supplemented the fiscal stimulus by doubling the central bank’s balance sheet during the two years ending early 2022, and by maintaining near-zero interest rates. Studies indicate that a significant portion of the overall stimulus may still be in consumers’ wallets. The additional liquidity pushes up the overall level of prices, with the specific sector affected depending on where the spending is directed.

Fed officials’ realization that inflation is not dead is why several of them have come out in recent public speeches advocating further monetary tightening. And while it has been clear for a while that the June headline inflation rate is likely to be a benign one, Powell emphasized repeatedly — in his press conference on June 14, and in his presentations in Sintra, Portugal and Madrid at month’s end — that an increase in rates on June 26 was virtually assured.

Having underestimated inflation in Fed decisions during 2020 and 2021, calling the price pickup “transitory”, Powell appears to have realized that the softening of such pressures may also prove to be transitory. Markets will wait to see if he sticks to his belief.

Dr. Komal Sri-Kumar

President

Sri-Kumar Global Strategies, Inc.

Santa Monica, California

srikumar@srikumarglobal.com

@SriKGlobal

July 15, 2023

Sri-Kumar Global Strategies, Inc. advises multinational investors and sovereign wealth funds on global risk and opportunities.  Dr. Sri-Kumar is regularly featured on business TV and Radio media, and is a frequent speaker in global financial centers on major topics that affect markets and investments.

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