Are We Really About To See Another Inflation Spike?
Summary & Key Takeaways:
Inflation looks set to bottom at a structurally higher base, and one that is uncomfortably high for the Federal Reserve.
But. we should expect Headline CPI to trend sideways for the time being. Upside pressures from goods and good inflation should offset some of the decline from rent and services inflation. The latter should continue to see Core CPI trend downwards.
Although the data doesn’t necessarily support it, this should be enough for the Fed implement one or two rate cuts they badly wish to make.
At this stage, it is also hard to envision any material upside spike in CPI at any point this year. This appears more likely a story for 2025 than 2024.
The current inflation picture
The past 18 months have seen a lot of positive developments on the inflation front. But, it appears increasingly clear a return to 2% inflation is an unlikely outcome any time soon. Though I do not believe another material upside move in inflation is likely to unfold this year, US inflation looks set to bottom at a structurally higher low than we have seen at any point over the past couple of decades.
Headline inflation looks to have bottomed, while the stickier services heavy inflation measures below are slowly but surely losing downside momentum.
What has driven most of the move lower in inflation has been a swift decline in goods inflation to such an extent Goods CPI has been in outright deflation for months now. Energy CPI has also seen periods of deflation, while Food CPI has largely been a non-factor since early 2023. Both have assisted greatly in the decline in Headline CPI.
Thus are, we have not seen a big enough decline in services and shelter inflation. Though lower services inflation is most likely imminent over the coming quarters, the fact goods inflation has seemingly already bottomed is a concern, as we shall see.
Inflation and the business cycle
As ever, when it comes to inflation, we must remember it is a lagging economic indicator. The most lagging in fact. Inflation data of today is a reflection of where the economy was six to 12 months ago. Upon understanding this, we are able to better gauge the general trajectory of inflation on a forward looking-basis. The below chart illustrates the leads and lags of the business cycle, and inflation’s place within.
As such, given the business cycle lead indicators in both the US and abroad are suggesting global growth should trend sideways to higher over the coming nine months or so, we are likely to see upside inflation pressures over this time that naturally emanate from the business cycle. We can see below how the ISM Manufacturing PMI tends to lead YoY CPI by around nine months to a year.
An accelerating global business cycle is thus most likely to result in accelerating manufacturing activity. This generally translates to inflation via higher manufacturing prices. Again, as we can see below, this has slowly started to play out and should elicit some upside pressure to the goods portion of the CPI basket over the coming quarters.
The same can be said of commodity prices overall.
Goods CPI should start to surprise to the upside
Thus, on a holistic basis, accelerating global growth should translate into some upside inflation pressures as we progress through 2024. We should see this primarily in Goods CPI (~19% of Headline CPI), which is the portion of the CPI basket that is inherently volatile and most responsive to the business cycle (the larger services inflation component is much more lagging, as we shall delve into shortly).
Core goods inflation has been outright deflationary for much of 2024 and has been one of the primary drivers of declining Core CPI (with Core Services CPI proving sticky). On a forward looking-basis, the leading indicators of goods inflation are no longer wholly supportive of this dynamic. In fact, they are suggesting we should begin to see Core Goods CPI turn higher as we progress through year end, or at the very least, cease being deflationary.
Indeed, as we can see below, retail sales growth - which tends to lead Goods CPI by around six months - has not been moving lower to the extent of goods inflation of late.
The same can be said of overall goods consumption. Although neither are yet to turn up meaningfully, these indicators suggest the downside moving in Goods CPI is likely near its end.
One area where we are yet to see leading indicators flow through to goods inflation is in relation to renewed supply chain pressures. While not overly extreme, we have seen the New York Fed’s supply chain pressure index tick higher over the past six months.
Driving this index higher has been in part the persistently higher container freight costs, which themselves continue to be hampered by global geopolitical tension and shipping lane disruptions.
At the very least, these renewed supply chain pressures should be enough to halt the decline in Goods CPI, though in isolation are not yet enough to cause a material spike in goods inflation similar to what occurred in 2021.
Renewed food inflation
I have been calling for a move higher in Food CPI in 2024 for some time now. Not only are slowly beginning to see this play out, but the leading indicators of food inflation are suggesting upside inflationary pressures should continue for the rest of 2024, but at this stage is unlikely to be a material driver of Headline CPI, given food constitutes only ~13% of the overall basket.
But we should see Food CPI moderately tick higher this year. This is certainly being suggested by Food Manufacturing PPI, which leads Foods CPI by six months.
Ditto the FAO Food Price Index, which has an eight-month lead versus Food CPI.
Fertiliser prices are also sending a similar message.
Don’t expect a big move higher in food inflation anytime soon. However, any upside pressures in Food CPI will work to offset some of the likely decline in services inflation, particularly if we see Goods CPI move higher as well.
Mixed signals for energy inflation
While the outlook for Food CPI is biased slightly higher, the outlook for its volatile counterpart, Energy CPI, looks relatively muted. Recent weakness in crude oil and gasoline prices probably have not fully translated into lower energy inflation as of yet (as we can see below), so we could see short-term downside in Energy CPI.
Beyond the short-term, I don’t see 2024 as a year where oil prices can spike meaningfully to the upside. Oil prices seem to have a short-term ceiling given the incentive for the Biden administration to further release barrels from the SPR pre-election, in addition to the market having to work through increased OPEC+ production come Q4. I also do not see significant downside for oil prices from here. Thus, Energy CPI is likely to be relatively muted until at least until 2025.
Energy Services CPI on the other hand, is probably more likely to see upside pressures this year, if only moderately. Natural gas prices play a large role in this component of the CPI basket (~3% of Headline CPI), and as we can see below, the recent run-up in prices is likely to continue to translate into moderately higher Energy Services CPI. I also believe natural gas prices are likely to be fairly well supported over the coming 12 months once the US works through the storage glut and the impending LNG export capacity that is set to come online at the end of 2024. We must remember however; weather will always be the wildcard when it comes to natural gas.
Services inflation - the key to it all
Overall, the key to the overall trend in both Headline and Core CPI will be services inflation. The biggest components of the services component of CPI (which itself is 61%) are Owners’ Equivalent Rent CPI (27%), Rent CPI (8%) and Core Services CPI (26%), of which the latter two are primarily a function of wage growth, as we shall see.
Beginning with the former, Owners’ Equivalent Rent (OER) is the largest component of services inflation and has historically been a function of US house prices. As we can see below, house prices lead OER CPI by around 12 months, and suggests there is plenty of room to continue to the downside for at least the rest of 2024. How long the deceleration in OER lasts will likely be the key determinant of when we see the next notable move higher in inflation, and the fact that house price growth has ticked higher over the past six months suggests at some point in the not-to-distant future, the decline in OER will end.
In terms of rent inflation, various measures of rental growth in the US continue to suggest Rent CPI continues to decelerate to the downside for at least the next quarter or two, before stabilising. The Zillow Observed Rent Index is one such measure, and suggests a return to pre-COVID levels.
As is CoreLogic’s Rent Index, which also has returned to pre-COVID levels.
Michael Ashton (AKA The Inflation Guy) is also forecasting a continued decline in Rent CPI for the rest of 2024, before a pick-up early next year.
Source: The Inflation Guy
Ultimately, the path of rent inflation and services inflation overall will be determined by wage growth, given non-goods inflation is itself primary a function of wages.
And, as we can see below, the lead indicators of wage growth continue to suggest wages should decelerate for the rest of 2024 and into early 2025. Whether wage growth returns to pre-COVID levels remains to be seen at this stage.
As such, we should expect to see Rent CPI and Services CPI continue to decline for much of the rest of 2024, though it is likely this decline will be at a slower pace than what we have seen over the past year.
Overall, inflation lead indicators are neutral over the medium-term
So, we seemingly have a situation where services inflation should continue lower as wage growth falls, while goods inflation and food inflation are likely to exert upside pressures, thus potentially offsetting some of the decline in services inflation. Overall, this suggests Headline and Core CPI should remain relatively benign around the 3% level for the rest of 2024, with Core CPI probably set for further downside (if only minimal). Several other leading indicators of inflation seem to be supporting this outcome.
For one, the YoY change in the dollar suggest the 12-month change in YoY CPI should hover around 0% for the next six months. Given Headline CPI was around ~4% 12 months ago and is currently ~3%, the dollar is pointing to Headline CPI of between 3-4% over the next six months.
Financial conditions have a similar forecast.
Meanwhile, the ISM Services Prices Paid index continues to point to sideways headline inflation readings over the next quarter.
The various regional Fed price surveys are suggesting something similar.
While the NFIB Plans to Raise Prices survey suggests we could see some downside in CPI over the next quarter.
This is something my own CPI Nowcasts are suggesting. Though my Composite Inflation Lead Indicator is suggesting slightly higher CPI over the coming months.
It is also worth noting inflation base effects are set begin to start biasing Headline CPI to the upside from here. They are more favourable toward Core CPI for the next quarter.
In all, there is simply not enough evidence to suggest inflation is likely to spike meaningfully higher to the upside at any point in 2024. Conversely, it is also difficult to argue for a return of Headline or Core CPI back to the 2% level any time soon. Yes, services inflation will continue moving to the downside in 2024, but we should expect upside pressures in goods inflation to partially offset this.
While this isn’t the ideal outcome the Federal Reserve will be hoping for, as I detailed here, I suspect the progress seen thus far on the inflation front and the somewhat favourable inflation outlook for the next six to nine months will be enough to justify one or two of the rate cuts and tapering of QT they so badly wish to undertake. Current inflation data doesn’t support this, but nor does it support any rate hikes. That should be enough for J-Powell and Co.
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