Concerns over acceleration in US inflation

US inflation in April is twice as high as expected. This inflation accelerated across a broad front, but there were some significant outliers. The US labor market remains crucial in terms of inflation in the somewhat longer term.

Financial markets were shocked this week by the US inflation data for April. Higher inflation has been a long time coming. There are several reasons for this. First, there is a 'base effect'. Because prices fell during this time last year, inflation is now rising compared to 12 months ago. We don't have to worry about that so-called basic effect.

Second, commodity prices have risen sharply recently. Third, last year's massive economic shock and the remarkably strong recovery in parts of the world have caused all sorts of logistical disruptions. As a result, supply chains are disrupted and that leads to price increases.

I don't want to discourage anyone from reading the rest of this commentary. If you don't want to read, you should definitely take a look at the pictures. But let me briefly answer 4 crucial questions.

1. How fast is inflation rising?
   I estimate that US inflation will rise above 5% in the near future and core inflation on the CPI measure to around 4%. In Europe, I expect a more moderate increase.
2. Is higher inflation temporary or permanent?
   The rise in inflation is quite broad, so I don't think we're going back to extremely low inflation in the US any time soon. Where there are very strong price increases, prices seem to be normalizing towards pre-pandemic levels. Or is the strong price increase due to special and probably temporary factors. Inflation of 5% seems temporary to me. The greatest danger that inflation will remain relatively high for longer is the tightening of the labor market. For the time being, there is clearly a tighter labor market in the US, but this has not yet led to faster wage growth. Here, however, we must keep our finger on the pulse.
3. How will central banks react?
   They will wait for the time being. They keep saying that the rise in inflation is temporary. I'll be surprised if they come back to that in such a short time.
4. What does this mean for financial markets?
   I think they remain quite nervous. Effective bond yields do not protect against any inflationary setbacks. And asset allocators are apparently heavily overweight stocks. So that's vulnerable in the short term. Investors don't know any more than central banks whether the higher inflation is temporary or not. The rather laconic attitude of the central bankers can cause unrest from time to time. An old saying is that investors can rest easy when central bankers panic (because then they certainly ensure that inflation doesn't have a chance). But with central bankers repeating "get some sleep," investors should be wary.

The tricky part is that we are in uncharted territory. Never before has the economic contraction been so abrupt as last year. The contraction has seldom been so sharp, never before have so many countries been affected by economic contraction at the same time. Never before have policymakers reacted so quickly and vigorously to absorb and compensate the damage. This led to a remarkable recovery, which is actually stronger than previously expected. Figures and experiences from the past provide less guidance than usual when we try to paint a picture of the future.

Clear Prelude
We have been seeing a harbinger of higher inflation at the consumer level for some time now in the price development of wholesale prices, and so on. This week, for example, wholesale prices for April were published in Germany. The first graph shows the development of those prices over 4 months, but then converted to a percentage that occurs if the rate of increase of those 4 months continues for a year. Economists sometimes call this 'inflation in the pipeline'. The last time price increases were recorded over a 4-month period that were higher than today was in 1974. 

US inflation much higher than expected in April
In the eurozone, this pipeline inflation has not yet reached the consumer level to a large extent. In the US, however, inflation in April, measured by the Consumer Price Index (CPI), was much higher than expected: 0,8% compared to March (only half had been expected) and 4,2% compared to March. compared to April 2020. In March, year-on-year (yoy) inflation was still 2,6%. The increase from 2,6% to 4,2% is therefore the result of the increase in April of 0,8% and the decrease of 0,7% in April last year, the base effect.

With prices falling again slightly in May last year, yoy inflation is likely to pick up sharply again in May, possibly reaching 5% or even higher. As mentioned, we have to look beyond the basic effect that is partly responsible for this. Core inflation was even 0,9% mom in April, the highest monthly increase in about 40 years.

Have fun rooting in the numbers
When confronted with such inflation figures, you have to look at the figures in detail to see if there are any special developments. I think that digging into the numbers yields the following. Three things stand out. Used cars and trucks became 3% more expensive in 1 month, the largest monthly price increase ever recorded for this category, airline tickets became 10,0% more expensive and 'lodging away from home', so say hotels, motels, B&Bs, and so on, 10,2%. These 8,8 categories together make up only 3% of the total basket of the CPI. Nevertheless, half of the total inflation in April of 4,2% was caused by these 0,8 categories.

The question that this raises is how broad the acceleration of inflation actually occurs. The Cleveland Federal Reserve publishes 2 alternative measures of inflation based on the CPI. The so-called 'median CPI' ranks all products according to the rate of the price increase, taking the price increase of the product that is exactly in the middle of that row. The 'median CPI' shows no acceleration at all and has been around 2% for months.

A second alternative measure is an average, but it ignores some of the most extreme observations. After all, extreme observations can strongly influence the average. The '16%-trimmed CPI' excludes the 8% products with the highest and 8% products with the lowest price increases. The following chart shows the month-on-month development and shows that the increase in April was quite strong.

In other words, inflation accelerated across a broad front in April. In the year-on-year chart that follows, it can be seen that everything is still not that bad on that basis. The conclusion I draw is that the April inflation figure was very disappointing, that inflation is somewhat higher across a broad front, but that the April disappointment was mainly due to a limited number of products and services.

Leaving aside the categories where the biggest price increases are occurring is obviously a bit lackluster. In this way you can 'relativize' any acceleration of inflation. It is also interesting to look at those categories. In the following chart I have therefore included the indices of the three fast risers.

My interpretation is that the rapid price increase in April for airline tickets and overnight stays is no more than a return to a price level that was normal before the pandemic. Prices here will continue to rise as life normalizes. There is clearly something else going on with used cars and trucks. This may have to do with catch-up demand for cars that cannot be met from new vehicles, because production is limited due to, among other things, a global shortage of chips.

Temporary or permanent?
Whether the higher inflation turns out to be temporary or whether we have to count on higher inflation for a longer period of time depends mainly on how wages develop. The view is somewhat clouded. Traditionally, economists in the US look at average hourly wages. That measure provides little insight. Last year, a phenomenal number of low-paid jobs were lost. As a result, the average hourly wage of the remaining jobs rose, but that actually says nothing about the real wage development. We are talking about a composition effect here.

The Federal Reserve of Atlanta publishes a series called, 'Median wage tracker', which shows the median wage development. This is shown in the following chart. This series suggests that not much is happening in terms of wages. The graph does raise questions. In the previous crisis, the rate of wage growth dropped very markedly. Didn't that happen at all last year?

In our own country, the employers' organization AWVN publishes figures about how strongly negotiated wages rise in concluded collective labor agreements, in which they try to calculate what the increase is on a 12-month basis. The following chart shows that the crisis last year quickly led to a decline in the rate of wage growth in our country. There was a stabilization in the second part of last year, but there is no sign of an acceleration as yet. Keep in mind that our labor market is lagging behind the American one.

Last week I briefly reported on the disappointing job growth in the US in April. There is an ongoing debate among economists about this setback. Some believe that the benefits are too generous. In addition to the usual benefits regulated by individual states, which vary from state to state, the federal government pays a maximum of USD $300 per week to the unemployed. In some states, that brings the total benefit level well above $3.000 per month.

Perhaps that's why people choose to remain unemployed rather than work. Janet Yellen, the Minister of Finance, disputes that it is the level of benefits. After all, then you would expect job growth to disappoint most in states where unemployment benefits are highest. Yellen believes that is not the case.

The fact that the labor market is quickly becoming tighter was shown this week by the further decline in applications for unemployment benefits. The JOLTS report (Jobs Openings and Labor Turnover Survey) also suggests that the labor market is quickly tightening. In March, more than 8,1 million vacancies were open, a record, as my last picture shows. In the last 3 months, 1,5 million vacancies have been added. You should fear that a continuation of this trend will lead to a clear acceleration in wage growth. This in turn translates into sustainable (somewhat) higher inflation.

Hans de Jong

Han de Jong is a former chief economist at ABN Amro and now a resident economist at BNR Nieuwsradio, among others. His comments can also be found on Crystalcleareconomics.nl

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