BIX ARTICLE
Is Inflation Under Control? - A Rocky Path Ahead
May 15, 2023
|
7 min read
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| 1 Introduction |
Since the beginning of 2023, the financial market has been exuberant and filled with optimism that the U.S. inflation would be tamed sooner than expected. This led to expectations that the Federal Reserve (Fed) would not be as hawkish as they were in 2022 in which they raised the benchmark Fed Funds Rate by 425bps to between 4.25% and 4.50% as at year end. The aggressive Fed monetary policy has led investors to believe that a recession or slowdown is inevitable and thus, will bring the interest rate hike to a halt.
In this research paper, we will discuss the factors leading to this market optimism and delve into the potential potholes, or even pitfalls that await investors. The path forward is not straightforward and as with past years, will remain rocky and uneven.
| 2 Optimism |
Some of the factors leading to the belief that inflation is cooling off at the start of the year include the consumer price index (CPI) growth rate which has been trending lower since middle of 2022, the high base effect of the inflation as well as slowing monetary growth judging from the decrease in the Fed’s balance sheet.
Chart 1: CPI (Y-O-Y Growth Rate)
| 3 Potholes |
That being said, it is still a long way to go before inflation drops to a more palatable level for the Fed, i.e. 2% to 3%. Looking at Chart 1 above, there is no doubt the inflation as measured by the CPI has been trending lower as the Fed was extremely hawkish in 2022 due to the persistent inflationary pressure caused by supply chain disruption and the Russia-Ukraine war. Nonetheless, if we were to scrutinise the components of the CPI, which could be separated into Flexible and Sticky Price CPI, then perhaps things are not as straightforward as they may seem.
Flexible Price CPI - calculated from a subset of goods and services included in the CPI that change price relatively frequently. As flexible prices are quick to change, it assumes that when these prices are set, they incorporate less of an expectation about future inflation. Evidence suggests that this flexible price measure is more responsive to changes in the current economic environment or the level of economic slack. Historical data suggests these items tend to change prices in less than 4.3 months on average. For instance, these items include gas and fuel, food, fruits and vegetables, car and truck rentals, lodging away from home, motor vehicle parts and equipment, apparel and footwear, etc.
Sticky Price CPI - calculated from a subset of goods and services included in the CPI that change price relatively infrequently. As these goods and services change price relatively infrequently, they are thought to incorporate expectations about future inflation to a greater degree than prices that change on a more frequent basis. One possible explanation for sticky prices could be the costs firms incur when changing prices. Historical data suggests these items will take more than 4.3 months on average to change prices. For instance, these items include household furnishings and operations, motor vehicle insurance, medical care, personal care products, recreation, communication, public transportation, rent of primary residence, etc.
If we exclude the more volatile food and energy prices, then both the Flexible and Sticky Price CPI trends are demonstrated in the following charts. They clearly show that the Flexible Price CPI has been trending lower since 2022, which almost coincides with the Fed rate hike period while the Sticky Price CPI has been trending higher since 2022 and oblivious to the Fed rate hikes in 2022.
Source: FRED
Chart 2: Flexible Price Consumer Price Index less Food and Energy
Source: FRED
Chart 3: Sticky Price Consumer Price Index less Food and Energy
| 4 Implication |
The implication of this observation means that on the surface, inflation as a whole has been trending lower but the most difficult part of the inflation, which is represented by the Sticky Price CPI, has not been responding to the Fed rate hikes. Since the Sticky Price CPI incorporates expectations about future inflation to a greater degree and has not been coming down after all the hikes, the Fed has no choice but to take a harder stance on inflation.
Otherwise, the inflation may become entrenched as a result of the inflation expectation and this will cause inflationary pressure to persist at the current level around 5% to 6% instead of the Fed target range of 2% to 3%. Once this is established, it would make the future fight against inflation harder.
| 5 Wage Growth |
Historically speaking, wage growth plays a major role in inflation expectations. Employees demand higher wages if inflation expectations are soaring or even entrenched at an elevated level. Let us take a look at the wage growth in the U.S. over the years.
Source: FRED
Chart 4: Average Hourly Earnings of All Employees, Total Private (Y-O-Y Growth Rate)
As shown in Chart 4, wage growth as measured by the average hourly earnings of all employees in the private sector is still above 4% despite showing signs of a slowdown recently. Sticky Price CPI will stay elevated unless wage growth gravitates to around 2% to 3% as shown in the years before the Covid-19 pandemic wreaked havoc in the employment market.
| 6 Unemployment Rate |
In order for wage growth to decelerate, the job market has to slow down as well. The recent unemployment rate, which is around 3.4%, clearly shows that the job market has not slowed down that much.
Source: FRED
Unemployment Rate
| 7 Conclusion |
Notwithstanding the decelerating trend of the CPI recently, the U.S. inflation still has a long and rocky path ahead before reaching the Fed target of 2% to 3% as the Sticky Price CPI is still hovering at elevated levels even though the Flexible Price CPI has already fallen. Before inflation expectations becomes entrenched, wage growth and the job market have to cool down first. However, these phenomena are not yet observable at this juncture.
Source: [BPAM] Is Inflation Under Control? – A Rocky Path Ahead (2023, 15 May). BPAM MARKET AND PRODUCT RESEARCH. Retrieved from BPAM
The information provided in this report is of a general nature and has been prepared for information purposes only. It is not intended to constitute research or as advice for any investor. The information in this report is not and should not be construed or considered as an offer, recommendation or solicitation for investments. Investors are advised to make their own independent evaluation of the information contained in this report, consider their own individual investment objectives, financial situation and particular needs and should seek appropriate personalised financial advice from a qualified professional to suit individual circumstances and risk profile.
The information contained in this report is prepared from data believed to be correct and reliable at the time of issuance of this report. While every effort is made to ensure the information is up-to-date and correct, Bond and Sukuk Information Platform Sdn Bhd (“the Company”) does not make any guarantee, representation or warranty, express or implied, as to the adequacy, accuracy, completeness, reliability or fairness of any such information contained in this report and accordingly, neither the Company nor any of its affiliates nor its related persons shall not be liable in any manner whatsoever for any consequences (including but not limited to any direct, indirect or consequential losses, loss of profits and damages) of any reliance thereon or usage thereof.
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