Perhaps this morning's scorching CPI report can finally put to rest the argument that this is supply-driven inflation and the Fed shouldn't be fighting it. What we have now is broad-based, demand-driven, service/labor/housing inflation, and only the Fed can successfully fight it.
This is most obvious in the accelerating monthly gains in both headline and core CPI. If this were supply-driven pandemic inflation, these readings would have been hottest two years ago, and since then moderating substantially. Instead, these readings are accelerating now. The headline CPI rose 1.3% in June just from the prior month. As Nick Timiraos pointed out, that's equivalent to the entire annual gain we used to see as recently as December 2020--nine months into the pandemic.
Now, last month's pop was also driven by gasoline prices soaring to their peak of $5.01 a gallon nationwide on June 14th. Since then, pump prices have retraced to $4.63. So the headline CPI should cool in July. But what explains the surging core readings? Core CPI, which excludes both energy and food prices, rose 0.7% last month, when it needs to be gaining 0.2% or less to keep annual inflation around the Fed's 2% target.
The biggest drivers of core inflation last month, according to the Labor Department, were shelter (rent prices), used cars and trucks, medical care, car insurance, and new car prices. Let's grant that car supplies were definitely hit by the pandemic and ongoing supply chain issues. But car demand also surged at the same time, driven by the same factors that are driving soaring rents, stubbornly high home prices, and the "household furnishings" that also pushed up the core CPI last month.
Just last night, Deutsche Bank's Justin Weidner published a report noting, as we have been writing for months now, that "Inflation [is] becoming increasingly demand driven." Two-thirds of the inflation rate he now attributes to demand-driven components, and only a third to supply constraints.
"Demand-driven" is another way of saying "fueled by government stimulus," whether from the Fed or the fiscal side of the equation. Recall, the Fed grew its balance sheet by nearly $5 trillion after the pandemic hit, while fiscal policy contributed about $5.2 trillion of stimulus, per Christina Romer. The fiscal side has already dropped out of the picture (as embodied by Joe Manchin), but the Fed only now is racing to bring monetary policy from stimulative back to neutral--and by next year, likely constrictive.
Whether or not that sends the economy into recession in the coming months is kind of beside the point. Consumer prices have now surged 16% since before the pandemic hit, according to Peter Boockvar. Consumers' inflation expectations have already become "un-anchored" in the short-term, and most households already feel like they are in recession. The Fed is right to try and fix this mess now, which it could have prevented by tightening more aggressively six to twelve months ago.
Otherwise, the situation could get a lot worse. Policy "solutions" to fix inflation--like rent, price, and wage controls--are notoriously counterproductive. They could weaken the U.S. economy, and ingrain inflationary pressures, for years longer than necessary. Larry Summers has already floated tax hikes as one way to help lower inflation. Jason Furman responded to this morning's report by saying fiscal policy should "help" (i.e. slow the economy) through $500 billion of deficit reduction (i.e. tax hikes) and by slowing prescription drug prices via Congress.
As for the Fed, the case for another 75-basis-point rate hike at its meeting later this month now looks more convincing. In fact, Canada's central bank this morning just came out with a surprise full-point rate hike, taking its rate to 2.5%. Deutsche Bank thinks the U.S. needs to get rates up to around 4.1% by next year (from around 1.6% currently) in order to bring the economy back into a sustainable long-term equilibrium.
"Even as Fed officials have focused more attention on inflation drivers outside of their control, recent inflation data have been increasingly influenced by a factor they can impact through tighter monetary policy: demand," wrote Deutsche's Weidner (emphasis mine). And as his estimates show, the Fed still has a long ways to go on that front.
See you at 1 p.m!
Kelly
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