When inflation rose above 5% in June 2021 — after rises of 4.9% rise in May and 4.2% in April — the United States Federal Reserve (Fed), along with a number of investors and economists, were unimpressed. It was shrugged off with the view it was nothing and would prove transitory. They were also quick to point out the outliers: used car prices and gasoline prices were both up 45% year over year (y/y) in June. Outliers, yes; but people have to drive, and new cars are hard to find due to supply chain disruptions, so those outliers hurt.
Inflation remained above 5% in July, August and September. Then in October, US Consumer Price Index (CPI) inflation jumped to a 31-year high of 6.2% y/y.
A path for inflation in 2022
Inflation inertia is now getting hard to deny. Since the beginning of 2021, month over month (m/m) CPI inflation has averaged 0.6%, or three times the average during 2017–2019. Even if m/m inflation were to drop back to 0.2% in November 2021 and stabilize at that rate, y/y inflation would still remain above 6% until February 2022, and only in May could it be expected to drop below 5%.
By then, it will have averaged 5.4% over a full 12 months (June 2021–May 2022). The CPI reading jumped above the 0.2% trend line beginning in January 2017, as noted in the chart below. The U.S. economy has already more than fully made up for the price drops of last year’s pandemic lockdown, and with the passing of every month, it’s rising farther above the historical trendline.
The monetary policy framework the Fed unveiled in 2020 aimed to get inflation running above the 2% target for some amount of time. Mission accomplished. And now?
Suppose that m/m inflation remains at 0.6% for another six months (0.6% is also the average for the past 10 months). In that case, y/y inflation would rise above 7% in December 2021, peak near 8% in February–March 2022, and only drop below 5% around November 2022. In that scenario, inflation would average 5.4% over a full two years, 2021–2022.
Inflationary forces and expectations
Several forces could easily keep pushing monthly inflation higher.
- The labor market remains tight, which has been the case even after supplemental federal unemployment insurance benefits expired in September 2021.
- A National Association for Business Economics (NABE) survey suggests that labor shortages are likely to persist well into 2022. Employers are bidding wages higher, and more workers are quitting to secure higher pay.
- Housing inflation will add pressure, given the ongoing rise in rents and house prices.
- Supply bottlenecks are expected to last well into 2022, continuing to raise costs.
This brings forth another factor: the importance of inflation expectations. For several months, businesses and consumers have been concerned about rising costs and prices. Stubbornly elevated inflation has now begun to impact both inflation expectations and price-setting behavior. Recent surveys, including the University of Michigan and the U.S. Conference Board, show that consumers are increasingly concerned inflation will keep eroding their purchasing power going forward.1
Meanwhile, firms have been realizing that strong demand conditions give them more pricing power, which helps to offset rising costs and improve margins. There is a growing sense that we are transitioning from an environment of price stability and cost compression to one characterized by rising input costs and output prices.
In an October seminar, Fed Chair Jerome Powell conceded that the Fed’s patient approach might not be a perfect match for an environment of sustained supply bottlenecks and energy price increases. For the first time, he sounded more concerned about inflation than about unemployment.2
Bond markets have taken notice, and their inflation expectations have started catching up with consumers and businesses. The five-year break-even inflation rate — a measure of market expectations for CPI inflation over the next five years — rose to its highest level, above 3%. Market expectations of rate hikes also have turned decidedly more hawkish.
The uncertainty of inflation — and the need for adjustment — is far from over. The Fed announced it will begin tapering its asset purchases, but even so, its balance sheet will keep expanding through the middle of 2022 as the Federal Open Market Committee (FOMC) does not seem to be in a hurry to raise interest rates. Moreover, the balance of the FOMC seems likely to tilt even more dovish when the Biden administration will fill three vacancies in 2022.
And, 10-year U.S. Treasury yields at just over 1.6% certainly don’t look very high with headline inflation running at 6%. The Fed’s heavy presence in fixed income markets is still distorting prices, in our view.
In closing, there are still possible macro scenarios ahead: Maybe the economy is about to tank, or maybe it’s about to witness a productivity miracle. If not, however, all the signs suggest the bond market is still underestimating the inflation risk.