US inflation is not going to get better soon

The global economy has been struggling for some time with an increasing number of disruptions. First it was the spectacular increase in freight rates for sea containers. There were also supply problems for raw materials and semi-finished products, as well as price increases for raw materials. Subsequently, many companies were unable to find enough staff and the latest development is that there are energy shortages, which means that electricity is rationed or spontaneously cut out in some countries and prices also rise sharply.

These developments push inflation upwards and economic activity, ie economic growth, downwards. I don't remember any economists who predicted all this last year. When the problems arose, there was some slightly philosophical murmurs that closing the economy is easier than reopening.

Faced with these unexpected developments, central bankers immediately shouted in unison that the problems would be temporary and that higher inflation would also be temporary, so they wouldn't have to adjust their policies for it. Now it just lasts and lasts.

Nobody knows
This week, economists at credit rating agency Moody's wrote that supply chain problems will get worse before things get better. Jamie Dimon, the CEO of JP Morgan Chase, said the opposite this week, which is that the issues will be resolved quickly. My conclusion is that we have no idea how long this is going to take.

What we do know is that the longer inflation stays high, the more likely it is that processes will get underway that will sustain higher inflation. Many economists agree that this is the case when the rate of wage growth accelerates. Then the chance increases that a wage-price spiral will start. Now I don't think we're going to experience inflation figures like we did in the 70s, but a significantly more moderate increase in the rate of inflation could also have a major impact on the economy and on the financial markets. That's why I keep my finger on the pulse.

Definitely not reassured
The recent US figures do not reassure me at all. Inflation in the US was 5,4% in September. Excluding food and energy, the so-called core inflation amounted to 4,0%. These percentages are all close to the figures of recent months. On the upside, it was worth noting that monthly inflation was better than expected. Headline inflation was 0,4% month-on-month and core inflation was 0,2%. It is sometimes argued that inflation will peak before the end of the year and then decline again. For the US, that seems too optimistic to me. The strong monthly price increases only started in March of this year and it is therefore likely that the peak of year-on-year inflation will not be reached until February. If we get monthly figures similar to September's between now and then, headline inflation in February 2022 will be above 6% yoy and core inflation around 5%.

All right, don't let us panic. More important than the question of when and at what level the peak will be, is the question of how quickly inflation will subsequently fall and to what level. Ultimately, the central banks' target is about 2%, although they do not immediately get stressed if we are above that for a while.

The Cleveland Federal Reserve calculates an inflation rate excluding 8% of the products and services with the strongest price increase and the 8% with the weakest price increase and then determines the median price increase. This measure is an indication of the breadth of inflation. The graph below shows that there is also a clear increase here.

So it is not the case that only a few outliers push inflation upward. That was the case earlier this year. At that time, prices for second-hand cars, rental cars, overnight stays in hotels and airline tickets in particular pushed up inflation. All these prices are now falling. But that decrease is apparently offset by price increases elsewhere.

The importance of renting
In the US inflation basket, rents, including rents imputed to homeowners, have a weight of about 32% (in our country it is about 23%). These rents even make up 40% of the core inflation basket. The next picture shows core inflation (78,8% of the total inflation basket) and rent increase (or 'rent of shelter' as they call it).

Because of the great importance of rents, a forecast of rents is very important for an inflation forecast. The following picture shows the development of house prices and rents. The relationship is certainly not one-to-one, but it is clear that house prices have a major influence on rents and that this influence is felt with some delay. House prices have recently accelerated considerably. This suggests that the rate of increase in rents will also accelerate further in the coming period. It cannot be ruled out that the rent increase will approach 5% year-on-year in the course of next year. If that happens, core inflation can only fall to 2% if all other prices remain unchanged on balance. That doesn't seem likely to me. I therefore believe that US inflation will fall disappointingly slowly and little next year.

Wage growth appears to be accelerating
When I looked in detail at US inflation data for September, I also noticed how fast the prices of 'Full service meals and snacks', a subcategory of 'Food away from home', are developing. I show those prices in the following chart. I just translated the category as 'Restaurants'. Now this item doesn't carry a lot of weight in the inflation basket (3,1%), but the point is that this is a labour-intensive industry where there are currently staff shortages. Companies may be raising prices because they have to pay higher wages to get staff. If so, then it is an indication that a wage-price spiral may have started.

It is not easy to follow exactly what is happening with wages. The following picture shows the average hourly wages as included in the monthly jobs report. The interpretation of these figures is complicated by so-called 'composition effects'. When the pandemic hit, a disproportionate number of low-paid jobs were lost. As a result, the average hourly wages of the remaining jobs rose without the wages of those jobs themselves increasing. By now you would expect such disruptions to be a thing of the past, but caution is still advised. However, it seems that wage growth has been accelerating recently.

The National Federation of Independent Business conducts a monthly survey of members. One of the questions being asked is whether companies plan to increase staff salaries. The following image shows that a record number of companies are currently on the move (the series does not go back further than shown in the image). It therefore seems that a (further) acceleration of wage growth will occur.

Inflation in the US persistent problem
My main message this week is that inflation in the US is a persistent problem. Inflation may fall next year, but we are not getting close to 2%. I have a series of arguments for that. First, no one knows when the disruptions of production chains, container prices, the labor market and the energy market will disappear. According to the optimists, those problems should have been a thing of the past. I am afraid that the accumulation of disturbances will make them last longer. Second, inflation in the US is broadening rapidly at the moment. Thirdly, housing rents will follow the house price rise, that is to say upwards. The high weight of rents in the inflation basket will make a rapid decline in inflation more difficult. Fourth, there are now clear signs that wage growth is accelerating, increasing the likelihood of a wage and price spiral.

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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