Infocus - US Inflation Worries

HOW WORRIED SHOULD WE BE ABOUS US INFLATION

In this issue of Infocus, EFG Chief Economist Stefan Gerlach looks at the behaviour of US inflation as measured by the deflator for personal consumption expenditures (PCE). Recent rates are compared with a forecast to assess the behaviour of inflation.

There has been much concern about US inflation recently. The latest data showed the CPI rose in May, by 0.6% month-onmonth and 5.0% year-on-year, the highest annual inflation rate since 2008. The index of the deflator for personal consumption expenditures that was released on 25 June was also strong, with a monthly inflation rate of 0.4% and annual inflation of 3.9%.

One view that attracts considerable support among some financial market commentators is that inflation will stay persistently and uncomfortably high, reflecting a fundamental change in the economic environment that the Fed has yet to understand. These commentators worry about the Fed “falling behind the curve”, being too late to withdraw stimulus. Under this view, the Fed may suddenly change tack and sharply tighten monetary policy, potentially leading to a negative financial market shock. The other view, which appears to be held by many Fed policy makers, is that recent increases in inflation are very much what one would have expected given the decline in prices during the start of the covid pandemic last year. While inflation is likely to remain high for a few months, proponents of this view believe that inflation will decline towards the Fed’s 2% target in the second half of 2021.

Recent inflation data

To understand the recent behaviour of PCE inflation, it is useful to consider the base effect. To do so, it is easiest to use inflation computed using compounded growth rates.1 In this case, annual inflation in May 2021 is the sum of the 12 monthly inflation rates between June 2020 and May 2021.2 Similarly, inflation in April 2021 is the sum of the monthly inflation rates between May 2020 and April 2021. The change in annual inflation between April and May 2021 of 1.17% equals the difference between the new monthly inflation data in April 2021 (+0.64%) and the monthly inflation rate for April 2020 (-0.53%) that dropped out of the calculation (see Figure 1). This latter effect is referred to as the base effect.

These calculations make the important point that changes in 12-month inflation depend both on the new data and the old data point that drops out of the calculation. The recent pattern has seen the new data pushing up 12-month inflation In this issue of Infocus, EFG Chief Economist Stefan Gerlach looks at the behaviour of US inflation as measured by the deflator for personal consumption expenditures (PCE). Recent rates are compared with a forecast to assess the behaviour of inflation. and the old data that drops out pushing it down. One reason inflation has risen so sharply recently is that the price level fell as Covid struck in March (-0.27%) and April (-0.53%) 2020, reducing 12-month inflation at that time. But this decline in the PCE index pushed up inflation in March and April 2021 by the same amount as these data points dropped out of the calculations. To illustrate this, Figure 2 shows annual inflation and the change in annual inflation, which equals the difference between the new monthly inflation rate (orange pillars) entering the calculation of annual inflation, and monthly inflation rate (blue pillars) from a year ago that drops out from the calculation. The chart illustrates how the price falls in the spring of 2020 lead to sharp increases in inflation a year later. Since monthly inflation in May 2020 was 0.17%, the base effect lowered inflation by this amount in May 2021.

The outlook for inflation 

While recent inflation data has been strong, the Fed is insisting that its outlook for inflation has not changed. Apparently, the recent data do not appear to be at odds with the Fed’s view of the likely evolution of inflation in 2021.

To explore this issue, we estimate a simple forecasting model for PCE inflation on data for 2000-2020. The idea is that the model may produce forecasts similar to the Fed’s own forecasts of inflation. Next, we compare inflation from January to May 2021 with the forecasts. If the observed and forecasted inflation rates are substantively different, we must conclude that the model fails to explain the data, and that the behaviour of inflation has changed.

Figure 3 shows annual US PCE inflation and compares it with model forecasts from January 2021 onward. While the actual inflation rate in May was 3.84%, the forecasted inflation rate was 3.13%. The likelihood that actual inflation and the forecasts will be identical is of course nil. To judge whether this difference is so large as to suggest that the behaviour of inflation has changed, we use a ‘fan chart’ that shows the range of possible inflation rates that are compatible with the model.

The fan chart is constructed in such a way that the likelihood that actual inflation will fall in the lightest orange-coloured area is 80%, the likelihood that it will fall in the slightly darker area 60% and so on. The likelihood that actual inflation will fall in the darkest area is 20%. If actual inflation falls outside the forecasted range, we conclude that the inflation process, as captured by the forecasting model, has changed.

As can be seen, it never does. While inflation is a little high, it is not so high as to call the forecasting model into question.3 Looking ahead, the forecasting model suggests that inflation will decline over the summer months.

Conclusions

Investors worry that the recent rise in US inflation will continue, that the Fed has fundamentally underestimated the strength of price pressures, and that its delay in tightening policy will require a larger and more dramatic policy response when the Fed comes to realise the severity of the situation. Of course, there is always potential for the inflation process to shift, but the analysis here indicates that recent inflation data provide little evidence that a shift has occurred. Indeed, it is not surprising that Fed officials have reiterated their view that inflation is only high temporarily and will soon revert to more normal levels. Nevertheless, the risk of such a shift taking place has risen recently and we remain vigilant to its possibility, although that is only likely to become apparent - if it occurs at all - as the second half of the year progresses. In the meantime, the framework presented in this report provides useful guidelines to help us assess whether reported inflation data lies within expected norms or is cause for greater concern.

1 The difference between these and ordinary growth rates is generally negligible, except for higher inflation rates. For instance, the annual inflation rate in April is 3.52% if compounded growth rates are used and 3.58% if it is calculated in the standard way. 
2 This holds only approximately if standard growth rates are used.

3 Statistically, the likelihood of observing a forecast error of the size of the May error is about 24%. 

Important Information

The value of investments and the income derived from them can fall as well as rise, and past performance is no indicator of future performance. Investment products may be subject to investment risks involving, but not limited to, possible loss of all or part of the principal invested.

This document does not constitute and shall not be construed as a prospectus, advertisement, public offering or placement of, nor a recommendation to buy, sell, hold or solicit, any investment, security, other financial instrument or other product or service. It is not intended to be a final representation of the terms and conditions of any investment, security, other financial instrument or other product or service. This document is for general information only and is not intended as investment advice or any other specific recommendation as to any particular course of action or inaction. The information in this document does not take into account the specific investment objectives, financial situation or particular needs of the recipient. You should seek your own professional advice suitable to your particular circumstances prior to making any investment or if you are in doubt as to the information in this document.

Although information in this document has been obtained from sources believed to be reliable, no member of the EFG group represents or warrants its accuracy, and such information may be incomplete or condensed. Any opinions in this document are subject to change without notice. This document may contain personal opinions which do not necessarily reflect the position of any member of the EFG group. To the fullest extent permissible by law, no member of the EFG group shall be responsible for the consequences of any errors or omissions herein, or reliance upon any opinion or statement contained herein, and each member of the EFG group expressly disclaims any liability, including (without limitation) liability for incidental or consequential damages, arising from the same or resulting from any action or inaction on the part of the recipient in reliance on this document.
The availability of this document in any jurisdiction or country may be contrary to local law or regulation and persons who come into possession of this document should inform themselves of and observe any restrictions. This document may not be reproduced, disclosed or distributed (in whole or in part) to any other person without prior written permission from an authorised member of the EFG group.

This document has been produced by EFG Asset Management (UK) Limited for use by the EFG group and the worldwide subsidiaries and affiliates within the EFG group. EFG Asset Management (UK) Limited is authorised and regulated by the UK Financial Conduct Authority, registered no. 7389746. Registered address: EFG Asset Management (UK) Limited, Leconfield House, Curzon Street, London W1J 5JB, United Kingdom, telephone +44 (0)20 7491 9111.