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US inflation – Up and away again

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Mark Allan
 

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US inflation rose again by more than expected in May, but as was the case for April’s numbers, a large chunk of the upward pressure was due to sector-specific supply shocks related to the economy normalising. What does this mean for the outlook for inflation and US monetary policy?

For the second month in a row, core inflation surprised to the upside, rising by 0.7% on the month in May, and taking the annual rate to 3.8%, marking its highest level since 1992. With the economy being buffeted by various supply shortages, the pressures were most intense in goods prices.

However, as was the case in April, a number of categories saw truly outsized price increases, pushing up overall inflation: used car prices and car rental fees in particular continued to skyrocket in May.

Inflationary pressures have become broader

While the main story in this data release is continued distortions from reopening/supply chain pressures, the price pressures were more broadly based than in April. In particular, the historically cyclically sensitive housing sector has begun to normalise with sequential price increases running at rates similar to those seen before the pandemic.

The other sizeable part of services prices, medical costs, has remained subdued). That leaves the overall core services price inflation – the bit that is normally persistent – as having picked up from very low levels late last year, but still on the softer side relative to the US Federal Reserve’s medium-term goal for inflation.

Exhibit 1 - Housing and medical services are important for the medium-term inflation outlook

More data needed to change the Fed’s view

When the Fed sits down at its policy meeting next week, it will be trying to unpick this data to test its hypothesis that this burst of inflation will be ‘transitory’ and see what it says about the medium term. Nevertheless, policymakers probably won’t conclude much other than that the process of reopening the economy is noisy and two or three months of data is not enough to challenge their default assumption.

So, in all likelihood, the Fed won’t change its medium-to-long-term inflation outlook all that much, even though it will have to sharply revise up their end 2021 inflation forecast.

Which way for labour market and inflation expectations?

In the types of models the Fed uses to project inflation beyond late 2022 and into 2023, the key forces are labour market dynamics and inflation expectations.

The more hawkish members of the policy-setting committee will fret that the current surge in prices due to the reopening will push up on inflation expectations and be embedded in broader wage and price dynamics.

The more dovish members are likely to be led by chair Jay Powell toward the latest jobs data and argue that once the temporary supply factors that are holding back employment growth (such as the temporary, but very generous unemployment benefits) drop off at the end of the summer, disinflationary pressures will reassert themselves.


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