US: Inflation Bears Start To Growl

In contrast, we are all hoping that 2Q 2021 will be a period of economic re-awakening - the vaccination program will have gained momentum, the number of Covid cases and hospitalizations will have plunged thereby allowing Covid containment measures and economic restrictions to be lifted. With households and businesses free to spend, supported by high savings levels, low credit card balances, and additional government cheques, we are likely to see vigorous pent-up demand.

At the same time, there is justifiable concern that some supply capacity has been destroyed in some areas of the economy. Airlines have laid off staff and mothballed aircraft, many hotels, bars, restaurants, and gyms have gone out of business, while numerous retailers have shuttered stores. Consequently, vigorous demand coming up against supply constraints will allow for price levels to recover to pre-pandemic levels and possibly beyond very quickly. This could make the YoY inflation rates look alarming.

For example, assume airline fares, which fell 30% March-May 2020, return to pre-pandemic levels in May 2021, equivalent to a $100 flight becoming a $70 flight and then returning to a $100 flight. Well, the price of the flight going from $70 to $100 equates to an annual inflation rate of 43%, yet it is the same price as February 2020. Long story short, annual inflation rates are inevitably going to look bad.

Energy and dollar effects are marginal

We also recognize that higher energy prices could add to headline inflation. The Saudi Arabian production cut has helped to maintain the upward momentum in oil prices, which will increase the cost of gasoline and transportation costs more broadly. The weaker dollar, too, could help nudge import prices upwards although given the relatively “closed” nature of the economy – only 10% of economic activity is tied to international trade versus 30% plus for Europe - means that this impulse is often overstated.

Critically though, the sectors where there are most likely to be major price increases are small. Airline fares have a weighting of just 0.6 percentage points, hotels are 0.8ppt, car hire is just 0.1ppt while gasoline is only 2.8% of the total basket used to calculate the national inflation number.

Services dominate inflation and weak wages will weigh

Meanwhile, non-energy services make up 60% of the inflation basket, with housing alone accounting for 30% of the total. Actual rents in major cities are falling and owner equivalent rent is depressed for now. The contribution from these components will probably creep upwards as rising bond yields drag mortgage rates a little higher and house price increases start to feed in, but I don’t think this should be too concerning.

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