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For four consecutive months, consumer prices as measured by the Consumer Price Index (CPI) rose 5% from the previous year. The pace of inflation has raised concerns that the Federal Reserve could be wrong in describing inflation as transient. However, our research suggests that there may be more validity to the Fed’s claim than it appears. In this report, we discuss some evidence supporting the argument that inflation will be transient. We also discuss the possibility that inflation will last longer than expected as well as how long we expect inflation to normalize.
The latest CPI report showed that inflationary pressures have eased sharply over the past two months. Monthly inflation (which is more sensitive to gradual changes from annual comparisons) as measured by the CPI excluding the volatile components of food and energy (core CPI) has increased from from a 30-year high in April to benign levels in August. The reduction in inflationary pressures coincided with a sharp deceleration in monthly inflation for used cars and trucks. In August, prices for used cars and trucks fell 1.5% from the previous month. Falling prices for used cars and trucks have likely eased much of the pressure on the overall price index.
To help illustrate the impact that used car and truck prices have had on inflation, the chart above shows the contributions to the annual change in the CPI. Prices for used cars and trucks, shown in yellow, have gone from a relatively insignificant portion of the pre-pandemic CPI to about one-fifth of the annual increase in the CPI from May to August. This category alone has been the biggest contributor to inflation in recent months. The rise in used car prices has significantly increased the overall index and the impact is likely to be reflected in the numbers of the annual change in the CPI at least until mid-2022.
That said, we are not sure that a slowing or reversal of the rise in used car prices will automatically lead to lower inflation. There are other price categories that have yet to regain their pre-pandemic lows, and their recovery could offset declines in used car and truck prices. Shelter prices, for example, are still rising at a slower rate than before the pandemic, as people have been slow to return to cities. Meanwhile, increasing COVID-19 cases across the country have kept hospitals from raising prices for many services. Thus, it is possible that inflation will rise even further in the coming months as services continue to recover.
However, there is a risk of longer term inflation. As the graph above shows, the contributions of energy and food to the CPI have also increased in recent months. Rising shipping and warehousing costs have had a negative effect on food prices. These higher costs have forced companies to increase their prices or accept lower margins. Until now, companies have been reluctant to impose all costs on their consumers, but they may have no choice if prices remain high. In addition, energy prices have picked up in recent months as demand has picked up. The demand for energy products could decline over time, while new climate restrictions could make it more expensive to produce these energy products. While the recent ban on new drilling on federal lands hasn’t completely hampered production, it looks like the industry may be headed for a decline in the future. In response to this threat, it appears that energy companies have now focused on paying down debt and paying off shareholders rather than reinvesting in new drilling. If this trend continues and production falls, prices are likely to rise.
In our view, the rise in inflation is expected to subside over time, as supply chain disruptions and other
the distortions linked to the pandemic are disappearing. However, we are not convinced that inflation will return to its pre-pandemic level. We expect inflation could start to stabilize around mid-2022.
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This report was prepared by Confluence Investment Management LLC and reflects the current opinion of the authors. It is based on sources and data believed to be accurate and reliable. The opinions and forward-looking statements expressed are subject to change. This is not a solicitation or offer to buy or sell securities.
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