WHAT WAS KEEPING INFLATION ELEVATED?
In recent months, inflation was lifted by supply bottlenecks, stimulus money, and loose
monetary policy. As we navigate the uncharted waters of historically high global inflation, we
can best understand the underlying trends by taking an individual look at the various
components. Current inflationary reports are highly nuanced right now. Durable goods prices
are clearly past peak but in contrast, services inflation is not slowing down (Figure 1). As
consumers pivot to more services spending, travel-related consumer prices will likely take a
longer time to moderate relative to goods prices.
With all the talk on durable goods inflation rates decelerating but services accelerating, in
actuality inflation may not reach the preferred 2% target in the near term. Consumers may
have to live in a new world where inflation consistently runs hotter than the previous decade.
At least, that’s what global central bankers warned at a European Central Bank (ECB) summer
conference in Portugal. Reshoring production, newer health protocols, and tight labor markets
could keep inflation rates above the 2% long run average for the near term.
Policy makers must come to grips with a real possibility that inflation rates will not come down
to their preferred targets any time soon. The latest inflation report is a juggernaut for the
Federal Reserve (Fed) as they use blunt instruments to slow aggregate demand during a time
when inflation is also irritated by supply shocks. But good news may be looming ahead.
Inflation may eventually be less impacted by supply bottlenecks.
FIRST FACTOR: ROTATION IN CONTRIBUTORS MAY BE A BRIGHT SPOT
Inflation dynamics may be at a crossroad. Since the onset of the global pandemic, the
inflationary environment has been irritated by supply-related problems with ports, international
manufacturing shutdowns, and global shipping as primary challenges. And indeed, these have
been major factors in supply chains and inventory management. For example, auto
manufacturers are still hampered with ready access to necessary components.
Well, the good news is that as of the last inflation report, the supply contribution to inflation fell
and demand-driven contributions to inflation became more of a dominant factor. So, this fits
perfectly into the script for the Fed. We know their monetary policy tools, albeit blunt, are
suited for tamping down aggregate demand, and as Chair Powell himself warned, “Our tools
don’t work on supply shocks.”
Fed policy works on a lag, meaning that a Fed decision takes some time to filter through the
system, but we think that Fed monetary policy may actually be an important factor for
addressing the current inflationary problems in the U.S. as inflation rotates to a demand-induced problem and less of a supply-induced problem (Figure 2).
SECOND FACTOR: STRONG DOLLAR AFFECTING PURCHASING POWER
A strong U.S. dollar could help ease some of the pressure off of the high prices we have right
now. Of course, we know that a sustained strong dollar will eventually give us some greater
purchasing power in the global markets and will pull down import prices. The year 2022 started
out with import prices rising very quickly on a monthly basis. In just the 31 days of January,
import prices rose 2% and then import prices rose another 2% month over month in February
and roughly 3% in March. These import prices were running hotter than the CPI over that
same time period. As the dollar has rallied in recent months, import prices have also cooled.
For example, June import prices rose a mere 0.2%, the smallest increase in six months.
THIRD FACTOR: LOWER IMPORT PRICES ARE NET POSITIVE FOR TAMING INFLATION
It will take some time to filter through to the end consumer, but the recent trends in the U.S.
dollar could keep import prices at bay and by transmission, tamp down some of the importsensitive consumer prices. So a slowdown in import prices, partially attributed to a strong U.S.
dollar, is an important variable we think could ease these pesky levels of consumer inflation
CONCLUSION: WHAT DOES THIS TELL US ABOUT FED POLICY?
Our base case for the federal funds target rate at the end of this year is 3.50% with potential
for the terminal rate to eventually reach 3.75%. However, the nagging persistence of some
consumer prices or the rising risk of a contracting economy might change the plans for the
Fed. The Fed is widely expected to raise rates by 75 basis points in July and then downshift
rate hikes to increments of 50 and 25 basis points. Investors and policymakers know inflation
will likely stay above target for a while but both will focus on the direction of the change.
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The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a
market basket of consumer goods and services.
All index data from FactSet.
Personal consumption expenditures (PCE) is a measure of price changes in consumer goods and services released monthly
by the Bureau of Economic Analysis (BEA). Personal consumption expenditures consist of the actual and imputed
expenditures of households; the measure includes data pertaining to durables, nondurables, and services. It is essentially a
measure of goods and services targeted toward individuals and consumed by individuals.
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