With inflation running hot, the debate over its persistence rages on.
We expect an easing in the supply-chain issues later this year, but stepping in will be a cyclical demand-side push next year that will keep inflation above 2% and solidify the Federal Reserve’s comfort on meeting their inflation mandate.
As this unfolds, we anticipate the Federal Reserve will shift towards tighter monetary policy, with an adjustment to Quantitative Easing being its first priority by the end of this year.
Although inflation has been a talking point for several months, a 0.9% month-to-month jump in core CPI got everyone’s attention. This was the highest monthly increase in 40 years, compelling Fed Vice Chair, Richard Clarida, to note that this “was well above what I and outside forecasters expected.”
On a level basis, both core CPI and the Fed’s preferred inflation measure (core PCE) have already returned to where they would have been if inflation had grown uninterrupted at the Fed’s 2% target throughout the pandemic (Chart 1). Simply put, mean-reversion was quick.
Though the advance in inflation has been very strong, it’s too early to sound the alarm bell. We don’t think the central bank has fallen behind the inflation curve on monetary policy
Prices for used vehicles skyrocketed under a chain reaction of events (Chart 3). First, people’s transportation preferences shifted to vehicles and away from air travel and public transit. This transitory influence is already starting to normalize. Global shortage in semiconductors limited the ability of auto manufacturers to respond with new car production.
Researchers at the San Francisco Fed separated the components of core PCE inflation into COVID-19 sensitive and insensitive groupings (Chart 4). The “sensitive group” is clearly driving inflation higher and accounts for a little more than half the recent rise in core PCE inflation. The researchers also provide a detailed breakdown of pandemic sensitive inflation into supply and demand factors.
The data reveal that demand factors (from lost income) were a major drag on inflation for most of the last 16 months, whereas supply factors were lifting inflation. With the demand-side trends now reversing, it is compounding the supply factors that are forcing inflation higher.
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