The latest data released by the Bureau of Labor Statistics (BLS) in the United States shows that consumer prices surged 8.6% year on year in May. This is the highest annual rise since December 1981, dashing hopes that inflationary pressures may have peaked in the United States. This signals sharper interest rate hikes by the Federal Reserve.
Source: BLS
Inflated essentials
Price rises increased across the board indicating that inflation is very much an economy-wide phenomenon, with gasoline, food, and housing (shelter) leading the way.
Any respite from the decline in Energy Commodities in April was short-lived with the line item rising 4.5% in May due to ongoing supply constraints. Gasoline prices were up 7.8% in May. The situation was exacerbated by the shortage of skilled labor and investments in refineries across the US.
On an annual basis, energy commodities were up a whopping 50.3% with fuel oil rising 106.7%, which is the largest increase since data collection began way back in 1935. Roosevelt was president, Jesse Owens was unknown, and the atomic bomb was still 10 years away.
Food prices rose 10.1%, the sharpest rise since March 1981. Pressures on food-at-home prices were even more acute, rising 11.9%, a record increase since April 1979. Five of the six major grocery food indexes rose by above 10%, crushing low-income budgets.
The shelter index rose by 0.6% in May, which may seem relatively muted. However, this is the highest level since March 2004. Even though housing demand has fallen, prices continue to climb.
Source: US FRED
Have prices peaked?
Fundamentals suggest that Inflation will possibly rise further, and at the least persist at a high level.
Supply constraints are not immediately reversible. Even in China, the sustainability of easing restrictions in key metropolises is unclear. In a worst-case scenario, it is conceivable that the authorities may re-instate lockdowns in accordance with the zero-case covid policy. Even today, with local residential committees making final decisions on local lockdowns, bottlenecks are likely to emerge.
Russia is unlikely to step down from its offensive in Ukraine and will continue to invite sanctions, disrupt Black Sea shipping, and search for alternative land routes.
New oil supplies from the Middle East will not be able to compensate for the entire shortfall, especially while the Iran deal is still to materialize.
With the onset of the summer driving season in the US, gasoline demand is expected to stay robust, and with elevated crude oil prices and stressed refining capacity, prices will continue to rise, pinching the common person’s finances.
Lastly, statistics aren’t perfect. They are often lagging. A recent paper by the Federal Reserve Bank of San Francisco suggests that significantly higher home prices may only become apparent after a gap of two years later.
Household budgets squeezed
CPI data shows that the most essential products are becoming increasingly costly, exerting pressure on economically weaker sections of society.
In the recent past, inflation in the USA surpassed 8% on two separate occasions in the 1970s. The first period lasted 23 consecutive months from October 1973 to September 1975, and then 41 consecutive months from September 1978 to January 1982.
As per the US Census, being below near-poverty is defined as having an income below 1.25 times the poverty line income in the US.
In the graph below, we provide simple projections of the proportion of US citizens that may fall below the poverty line and the near-poverty category, if 8%+ inflation were to persist as it did in the 1970s and 1980s.
Data from 2020 is used as a proxy for the proportion of the population below the near-poverty rate in 2022.
Source: census.gov
The three scenarios predict that the near-poverty proportion of the population could rise from 15.3% to 17.0% by 2024, 19.7% by 2026, or 19.7% by 2031 if inflation persists above 8% and follows the same path as it did four decades ago.
Highlighting the dire situation among US households, the Energy Information Administration (EIA), noted that 17 million out of 118.2 million households received a disconnection notice in 2015. In 2020, Dominic J. Bednar & Tony G. Reames of the University of Michigan estimated that 37 million households were in energy poverty. More families would be pushed into this bracket as inflation rages.
JP Morgan strategist Mike Bell believes that finances are relatively robust since the pandemic-time fiscal “stimulus checks boosted savings.”
What comes next?
The fresh highs in inflation mean that the Fed will have no choice but to continue hiking rates till the end of the year, before re-assessing the situation. Talk of a Fed Pause in September is unlikely to occur in such an environment. However, this will certainly put the Fed’s rate hike resolve to the test.
Unsurprisingly, the DXY surged today to above 104.1 at the time of writing, nearing a one-month high.
As rates rise, demand is likely to contract. With the Q1 GDP contracting, former Fed-insider Danielle DiMartino Booth believes that a Q2 contraction is also possible, which may raise recessionary flags.
Although the Fed is targeting demand reduction and is intending to pull off an increasingly unlikely soft landing, much of the inflationary components are supply driven. It is unclear how effectively rate hikes will curb higher prices, while excessive tightening risks a stagflationary crisis.
According to the Federal Reserve, households and non-profit organizations in the US saw their net worth fall from half a trillion dollars to about $149 trillion during the first quarter. With quantitative tightening, financial assets are expected to become more volatile, creating fresh difficulties, especially for lower-income families.
Moreover, the University of Michigan consumer sentiment index has slipped to 50.2, the lowest level since records started in 1952. The index contracted sharply from the last month where it read 58.4, suggesting decreasing demand amid higher prices. The previous lowest was 51.7 recorded in May 1980.
This would prove to be a difficult challenge for President Biden in the run-up to the mid-terms, whillewhile markets will be awaiting the Fed’s guidance next week.
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