It has been over a year since COVID-19 ended one of the longest equity bull markets in US history. Governments and central banks responded quickly and, as a result, global equity markets have not only recovered but some have hit record highs. For much of 2020 and in early 2021, investors were concerned about activity levels being too low versus potential levels. However, over recent months, investors are now focused on whether rising US inflation will cause the US central bank, the US Federal Reserve (the Fed) to raise interest rates materially. The actions of the Fed can have a material impact on global markets given the size of the US economy and the importance of its financial system. This article briefly explores recent developments in US inflation and implications. We note that annual inflation in Australia is subdued at 1.1% for the March quarter 2021.
The Fed aims to promote: maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy. It uses a range of indicators to assess the inflation outlook. Its preferred measure is the core personal consumption expenditures (PCE) price index, which excludes the more volatile food and energy sectors. It aims to achieve 2% inflation over the medium term.
From a recovery perspective, the US economy is one of the most progressed in the world, which is one of the factors putting upward pressure on inflation. The chart below shows the 12-month percentage change in the US core PCE index since January 2000. The latest outcome for May 2021 of 3.4% is much higher than the Fed’s medium-term target of 2% and the highest outcome since July 1992. The chart also shows the core CPI inflation outcome for May 2021.
Figure 1: US Personal Consumption Expenditures & Consumer Price Index (Excluding Food and Energy, Seasonally Adjusted, 12 month % change)
Source: U.S. Bureau of Labor Statistics
While the recent inflation data have probably surprised the Fed, a key issue for investment markets is whether interest rates will rise earlier and by more than previously expected. The Fed has indicated that it believes that the recent increase in inflation is most likely transitory. That said, its latest interest rate projections include a slightly higher rates for 2023 than its prior projections.
The Fed believes that the rise in inflation largely reflects exceptionally strong demand that will fade over coming quarters, as well as temporary virus-related restrictions that will eventually be removed. Core inflation over the year to May 2021 has been high as a result of factors such as: large increases in used car and truck prices (up 29.7%); airfares (up 24.1%); and accommodation prices (up 9.0%). Price increase in the last two categories reflect the opening of the US economy recently.
In order to get a better gauge of underlying inflation pressures, the Fed uses a range of indicators. One is the median inflation rate, which is shown in Figure 2. It shows a more subdued inflation picture than Figure 1. This is because it does not include the higher inflation categories. The median inflation rate has picked up slightly recently and is now 2.1%. This suggests that underlying inflation pressures are moderate.
 For each month, the Median CPI reflects the one-month percentage change of the CPI component that is ranked in the middle of the price changes for all components of the CPI. It is a measure of underlying inflation pressure.
Figure 2: US Median Consumer Price Index (12 month % change)
Source: US Federal Reserve Bank of Cleveland
Another key area of focus for the Fed is the labour market, as it can have a large influence on inflation. When the unemployment rate falls to very low levels there are less available workers, which can result in rising wage growth that eventually causes rising inflation. Recently, wage growth has remained moderate.
Figure 3 shows that the current unemployment rate of 5.9% is considerably higher than the 3.5% level achieved just prior to the onset of COVID-19. This suggests that the labour market is unlikely to be a source of rising inflation soon. As the unemployment rate continues to fall and breaches 4%, the risk of rising wage growth increases.
Figure 3: U.S. Unemployment Rate (Seasonally Adjusted)
Source: U.S. Bureau of Labor Statistics
Looking ahead, short-term leading indicators of US inflation suggest that upward pressure will persist for at least a few months. Over time, the supply issues will probably lessen as the economy opens further and demand growth will likely moderate from its currently exceptionally high level. This would result in some downside pressure on core inflation (commencing perhaps later this year or early next year). A key risk is that the recent rise in US inflation turns out to be more persistent, resulting in interest rates rising more than currently expected. We continue to monitor for signs that this might be the case.
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