Inflation soars 9.1% but attention could turn to supply-side – A Deep Dive

In what has become (almost) commonplace, the US CPI headed higher once again, galloping to 9.1% on an annual basis in June and registering a 41-year high. The latest inflation print outdid both May’s reading of 8.6% and the Dow Jones’ forecast of 8.8%.

The much-anticipated US jobs report released earlier in the month registered a rise of 372,000 jobs in the month of June stoking inflation fears.

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Source: FRED

For everyday American workers, the situation remains dire with rapidly rising costs of living amid declining real incomes. As per the Bureau of Labor Statistics (BLS), average hourly earnings ended 1% lower during the month of June and nearly 4% lower over the past 12 months.

Annual and monthly rise in essentials

Source: BLS

The rise in inflation has been broad-based affecting nearly every category.

Over the past 12 months, energy, food, vehicle purchases, and shelter were higher by 41.6%, 10.4%, 11.4%, and 5.6%, respectively.

Gasoline prices, in particular, shot up, rising 59.9% while food at home was 12.4% higher, posing severe challenges for the average family.

On a monthly basis, the CPI rose 1.3%, the single largest monthly gain since September 2005.

Prices were led higher by gasoline and energy which increased by 11.2% and 7.5%, respectively. Gasoline prices in the US reached above $5 per barrel driven by Russian sanctions, low international output, and shuttered refining capacities.

Food at home prices rose by at least 1% for the sixth month in a row, reflecting shortages in fertilizers, elevated crude prices (in June), and ongoing supply disruptions in global agriculture.

Shelter and healthcare prices were up 0.7% and 0.6%, respectively. In a recent column, economists Stiglitz and Baker opined that with rising rates, the “sudden increase in borrowing costs has massively altered the shape of the housing market”, while the resultant shortage of new constructions and capital appreciation has driven rents higher.

Source: BLS

Medical-care costs climbed 0.7% on the month, driven by a 1.9% increase in dental costs, potentially due to rising costs of key raw materials such as platinum and palladium.

Rate hikes, crude oil and inflation expectations

With red-hot inflation, the Fed likely has no plans to ease its foot off the gas, in line with Chair Powell’s comments that “the clock is ticking” and “We need to see inflation coming down in a convincing way.”

Earlier in the day, the CME’s Fed Watch Tool was split near the middle, with 49% of respondents expecting a target range of 225 – 250 bps (+0.75%) and 51% expecting 250 – 275 bps (+1.0%) to be set during the next meeting in two weeks.

However, this moved dramatically to 22% and 78% of respondents, respectively, after the release of the Energy Information Administration’s (EIA) report on strategic reserves and crude inventories.

On July 13, the EIA data showed that crude inventories rose by 3.3 million barrels while Strategic Petroleum Reserves fell nearly 7 million barrels, the lowest levels since August of 1985.

Crucially, gasoline and distillate (including diesel) inventories were up by 5.8 million and 2.7 million barrels, respectively during the week.
This would ordinarily have signaled a severe slowdown in demand. However, the market saw heavy fuel purchasing in the run-up to the July 4th holiday

Matt Smith, lead oil analyst at Kpler expects today’s readings to be merely a “hangover”, while the Brent benchmark jumped to over $100 at the time of writing.

A gauge of one-year ahead inflation expectations, the Federal Reserve Bank of New York’s Survey of Consumer Expectations, has continued to rise from 2.5% in January 2020 and registered at 6.8% in June 2022, suggesting that respondents do not anticipate inflation to ease in the immediate future.

Inflation expectations are a perpetual concern for monetary authorities. Francesco D’Acunto et al (2021), noted that consumer expectations of inflation are greatly influenced by recent purchases of “grocery bundles”. As a result, the Fed would rather deploy its tools to thwart higher expectations on Main Street from being cemented into public psychology than risk fueling higher prices.

Supply-led challenges

Inflation appears to be largely dominated by supply-side blockages, amid the ongoing Russia-Ukraine war, recurrent covid lockdowns in China, and delayed deliveries.

Given the scale of these disruptions, in everything from semiconductors to baby formula, coupled with the sharp fiscal stimulus over the past two years and tight lockdowns, surging inflation was inescapable.

Standard economic theory suggests that monetary authorities have very little influence on supply shocks, and raising rates to curb supply-led inflation is usually not considered to be prudent policymaking.

Stiglitz and Baker write that “by making investment more expensive, they (the Fed) may even impede an effective response to supply-side problems,” and may exacerbate conditions.

Loretta Mester of the Cleveland Fed countered by stating that “In some circumstances, such (supply-led) shocks could threaten the stability of inflation expectations and would require policy action.”

Injecting optimism?

The S&P 500 has suffered its worst first six months since 1970, and is down 20.2% YTD at the time of writing.

The June report of the Conference Board found over 60% of respondents believed that business conditions deteriorated in Q2.

The National Federation of Independent Business (NFIB) which tracks small business sentiment, saw its index decline to 89.5 in June, the lowest level in nearly 10 years. 34% of respondents flagged inflation as the single biggest problem, the highest proportion to do so since the winter of 1980.

For President Biden, with inflation raging, lifting public morale is paramount ahead of the mid-terms in November. The Guardian reported that a whopping 64% of Democrats would prefer a fresh presidential candidate in 2024.

A poll conducted in end-June found that 52% of voters had an ‘unfavorable’ view of Kamala Harris, leaving the Democratic Party desperate for any positive news ahead of the mid-terms.

In particular, officials from the Council of Economic Advisers reflected on the strength of jobs numbers as evidence that a recession was not in the offing.

Russia has also been a key target in the blame game. Although the Ukraine invasion has been the latest trigger, it is also the case that many commentators flagged high inflation as a foreseeable risk, but was largely dismissed as “transitory” for the better part of the past two years.

A different medicine for u-turning

Although there is a general consensus that the Fed should hike rates, some economic voices do not believe that this will be sufficient to quell supply-led inflation.

As per Dean Baker at the Center for Economic and Policy Research, real wage growth in the period of March to May 2022 was 4.4% on an annual basis, slowing from 6% in late 2021.The US Bureau of Economic Analysis reported that real personal consumption spending growth slowed to 1.8% in Q1 2022 as compared to 2.5% in Q4 2021, adding weight to the idea that higher prices are primarily cost-led, and not due to excess demand.

Together, these two data points indicate that a wage-price spiral effect is less likely to hold sway than was earlier anticipated.

Policy normalization is turning out to be especially painful for lower-income families, with the effects perhaps most telling in the housing market. Mortgage rates have skyrocketed amid higher Fed rates, rising from 2.65% in January 2021 to nearly 6% today.

Ryan Severino of JLL notes that “the Fed has a poor track record of following through on its own forecast… (the market) does not believe the Fed and maintains a less aggressive forecast” than the stated 4% in 2023.

Stiglitz and Baker believes that supply-side solutions are being overlooked and are necessary for the current environment. Crucially, supply improvement would likely not hurt workers, unlike continued rate hikes.

Although these measures could go a long way in improving household finances, they are also time-intensive structural reforms that are uncertain to find quick success during such a polarized political setting.

With an end to the Ukraine conflict seeming like wishful thinking with every passing day, and market expectations that the Fed’s credibility to follow through on its hawkish plans is less than sound, supply-side measures to control inflation may become an increasingly prominent part of the inflation debate as the political news cycle intensifies.

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