Why high inflation is a rear-view mirror issue: explained in 10 charts
For many months now, I have been calling out June 2022 as the peak in the US’ current high inflation cycle, and that significantly lower inflation lies ahead. My confidence in such an outlook stemmed from the initial stagnation in the M2 money supply, which has now turned into outright DECLINES.
I view this as the single most important indicator that will drive inflation and the economy over 2022.
With the absolute level of the M2 money supply not moving since December 2021, the impact on CPI inflation has already become apparent. Its impact will only continue to grow. Let’s illustrate this through a bunch of additional charts:
A tale of two halves: MoM inflation rates have tanked
As can be seen in the chart below, while CPI inflation was growing at a VERY fast pace during 1H22, inflation was practically non-existent in 2H22.
The annualised 6-month change in the CPI was 13.0% in June 2022. Today? Just 0.3%.
So much for inflation being “sticky”.
3-month annualised CPI inflation turns negative
As a result of inflation rolling over during the past 6-months, for the first time since June 2020, 3-month annualised CPI inflation has turned NEGATIVE (albeit only just 🤏). Again, this shows how recent MoM CPI growth has materially changed vs 1H22.
Durables prices turn YoY NEGATIVE — just 10 months after being 18.7% higher!
In another warning to those who believe that inflation is a sticky phenomenon, durables prices turned YoY NEGATIVE in December — just 10 months after hitting their enormous current cycle peak of 18.7%!
Just as durables prices led the CPI higher as individuals spent stimulus checks whilst cooped up at home, they are now leading the CPI lower as real incomes fall.
Food price growth continues to moderate as the UN FAO Food Price index records 9 months of declines
While the YoY rate of growth in CPI food at home prices continues to be brisk at 11.8%, recent MoM growth rates have seen a significant moderation. This comes as the prices of underlying food commodities have fallen for 9 consecutive months (as measured by the UN FAO Food Price Index).
With the two measures highly directionally correlated after the CPI measure is lagged by 6 months, we can see that yet again, YoY CPI food at home prices have started to turn lower. The pace of YoY deceleration in CPI food at home prices should quicken in the months ahead as high prior year comparables are cycled.
With underlying food commodity prices seeing 9 consecutive months of outright declines, and broader inflation pressures moderating, there has been a closing of the gap between the monthly price change in food at home prices versus the MoM price change that was typically exhibited over the decade to 2019. Again, this shift towards price moderation saw a significant 1H22 vs 2H22 pivot.
I expect the gap between upcoming MoM growth rates to continue to bridge towards historical MoM average changes. Should underlying food commodity prices continue to fall, then I see a material likelihood of the relationship turning negative in the months ahead (i.e. the monthly change in food at home prices to be LESS than the historical average monthly change that has been typically observed).
Gasoline prices tank after hitting highs in June
After peaking in June, gasoline prices have since staged a major turnaround. This has driven a major shift in the CPI’s energy commodities index, which has seen its YoY growth rate plunge from being 60.6% higher in June 2022, to a YoY DECLINE of 0.2% in December.
While oil prices are volatile and difficult to predict, and have rebounded somewhat so far in January, with M2 declining (which is likely to drive slower economic growth and a recession), there’s a significant likelihood that oil prices continue to drift lower, or at least remain around current levels. This would see ~double-digit YoY declines in CPI energy commodities from March 2023.
Spot market rents are recording significant MoM declines
While the CPI’s owners’ equivalent rent (OER) and rent of primary residence indexes continue to record significant MoM growth, it is critical to note that they measure rents with a MAJOR lag to actual spot market rates, as instead of measuring just the prices of new rental agreements in a given month, the CPI measures continuing rents.
Given that most rental agreements in the US are for fixed terms (most of which are for 12 months), it can take a significant length of time for the CPI’s rental indexes to catch-up to major short-term changes in rental market prices (the likes of which we have seen over the past two years).
Looking instead at spot market rents, which provide a better indicator of the underlying price pressures occurring TODAY, we see yet another indicator of inflation pressures reversing to price DECLINES. Again, this provides a further key example of high inflation being a rear-view mirror issue.
With the CPI’s rental measures lagging, they instead continue to record high MoM growth rates, as they play catch-up to the prior increases in spot markets rents that they are yet to fully capture.
Services ex-shelter peaked in September: higher comparables to be cycled from January
While services prices have continued to rise in recent months, with the YoY rate increasing from 7.2% to a new high of 7.5% for the current high inflation cycle in December, much of this is due to the aforementioned significantly LAGGING shelter costs.
Given the lagging nature of rental measurement in the CPI, to gain a better understanding of CURRENT services inflation rates, we need to either adjust, or exclude, the shelter component.
Fortunately, the BLS makes this easy, as it provides a services dataset that excludes shelter costs. Here we see that the YoY growth rate is similar to the entire services category at 7.4% (vs 7.5%), BUT this is well down on the 8.2% peak that was recorded in September. Indeed, the 3-month annualised growth rate has fallen BELOW 1%, whilst the 6-month annualised growth rate has fallen from 11.8% in June 2022, to just 3.3% in December.
As higher comparables are cycled over the months ahead, the YoY growth rate of CPI services ex-shelter should fall significantly, as has occurred for the 3- and 6-month annualised measures.
CPI ex-shelter falls 0.8% MoM — now under 6% YoY from 10.8% in June
Given the aforementioned discussion around shelter costs on CPI services prices, it is now worth highlighting the level of overall CPI inflation ex-lagging shelter costs. Despite peaking at a higher rate of 10.8% in June (vs 9.1% for the overall CPI), the YoY growth rate for CPI ex-shelter is now BELOW the overall CPI, falling to 5.9% YoY.
Again, this shows both the huge level of disinflation over 2H22, as well as how the CPI is being significantly propped up by LAGGING shelter costs, whereas the rest of the index has largely rolled over.
The 3-month annualised CPI ex-shelter growth rate has fallen from 15.4% in June to NEGATIVE 3.8% in December. The 6-month annualised rate has fallen from 15.9% in June to NEGATIVE 3.2% in December.
Virtually all signs point to lower inflation ahead — plan accordingly
While virtually all signs point to high inflation now being a rear-view mirror problem, with YoY rates set to fall significantly over the months ahead, remember that a falling M2 money supply doesn’t just mean lower inflation — it also often means that lower or negative nominal economic growth is ahead.
When a decline in M2 follows such a HUGE earlier increase in the money supply (which creates the conditions for MAJOR malinvestment & economic distortions), the risks of a SEVERE recession are high. This is what individuals and businesses should be preparing for. Forget high inflation for now. It’s no longer the primary economic concern.
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I will never understand what the Fed was thinking in 2020-21. Strict monetarism is out, but everybody thinks you get problems if you print too much money, and they printed twice as fast as ever before in modern history - even in the 70's! Just, WHY?
Yep, it's hard to fathom the virtually complete ignorance of changes in the money supply.
How the Fed could dismiss inflation at first given the underlying change in the money supply is beyond me.
But here they are now, repeating the same mistakes in reverse, with excessive tightening causing the first YoY declines in M2 for the first time in 60+ years.