Inflation Causes and Trends

I just got a bill for $23k in tarriffs thanks to your boy. "China is going to pay!" No, they don't. This is how tariffs work: Let's say I am a US consumer electronics company (I am) and I work with China based contract manufacturers to assemble our products (I do). When I need more product I issue a purchase order to our CM partner. They build the product and get it ready for shipment. (It's never this simple but this boy can dream) To move the goods out of China or HK, the shipper requires documentation including battery certification, commercial invoice, packing list ,and more. No docs = no ship. The commercial invoice is exactly what it sounds like. It states exactly how much I paid the CM for each product and the HS code for each. HS Code? What's that?? The HS code is a hyperspecific category of goods used internationally that Customs uses to determine the tariff rate. We research this ahead of time and claim the goods fall under a specific HS code category. But what is a tariff? A tariff is a tax paid by the importer that is a % of the value of the goods. For example, a 20% tariff means my thing that was $100 is now $120. But it doesn't change how much I pay the seller. I still pay them $100. The US Customs and Border Protection, aka the CBP, aka the US Government, get the $20. How does this all go down?? When my goods arrive, doesn't matter if they come by air or sea, I get an Entry Summary from the CBP via my customs broker. This document has all the details of the shipment including all the charges that need to be paid including duties (i.e. tariffs), Merchandise Processing Fee, etc. In summary, I pay my CM the same amount but now I have to pay the tariff as a tax back to the US government for the privelege of importing those goods. How does this affect the consumer? Eventually these cost increases get translated into retail price increases. Some companies may eat the margin compression initially but over time the market will trend back towards standard cost/price multiples. There is no way around it. Hello inflation!

The surprise to the upside on January’s #inflation numbers could complicate the Fed’s plan moving forward. If signals of ongoing inflationary pressure continue, particularly in the midst of potentially inflationary policies, a rate hike wouldn’t be completely out of the question this year, and further cuts less likely anytime soon. The FOMC paused their rate cuts as inflation progress seemed to slow, and while there isn’t a definite case for inflation climbing again, it’s also becoming more difficult to say that it’s moving in the right direction. Price growth quickened in the first month of the year, with inflation rising in food and shelter, among others. Progress on consumer inflation has stalled, and we’re all paying the price. But a fairly notable chunk of the increase in food prices — which we all interact with — is credited to eggs. Egg inflation rose over 15%. This doesn’t only impact at-home bakers and breakfast makers, but the restaurants that depend on eggs too. We saw last week that Waffle House, a bastion of inexpensive late night and morning meals, is adding an egg surcharge to cope with the impact of bird flu. That said, egg prices account for less than 0.2% of the total headline inflation index, so while they are a contributing factor, continued high price growth can’t be blamed on them alone. Used cars, shelter and transportation cost increases also played a role in quickening price growth for the month. #Wholesale inflation numbers due out tomorrow could provide insight into what consumer inflation could look like in the near future. #economy #data

The August CPI report showed further progress in #inflation making its way down to 2%, setting the Fed up to begin normalizing monetary policy next week with a quarter point rate cut. Headline CPI rose 0.2% m/m, which brought the year-over-year rate down to 2.5% -- the lowest rate we’ve seen since February 2021. However, core inflation was slightly warm +0.3% m/m and 3.2% y/y, largely due to stickiness in shelter as well as gains in airline fares and transportation services. 🏠 Shelter alone accounted for 1.8%-pts of the 2.6% increase in headline inflation this month, but is predictably coming down at a gradual pace. After rising 0.5% in August, the annual rate for owner’s equivalent rent CPI stands at 5.4% compared to its peak of 8%. Meanwhile, Zillow’s Observed Rent Index shows annual rent inflation for new leases has stabilized around 3.5% for about a year now, compared to its peak of 16% in the post-pandemic rental boom. CPI won’t reflect the full magnitude of this swing in market rent inflation, but it is a heavily lagged measure and compared to OER’s run rate of ~3.5% y/y pre-pandemic, we think there's more progress to come in the coming months. A few more pieces of “good news” on inflation worth mention: ➡️        Grocery store prices were flat m/m and are only up 0.9% y/y. Indeed, food at home inflation has averaged below 2% y/y since Oct. 2023. ➡️        Apparel prices are up just 0.3% y/y, a very different picture from its once 26% y/y rate in Jan. 2023. ➡️        Car prices are also down nicely, -9.5% y/y for used cars and -1.2% y/y for new cars. ➡️        Auto insurance, one area that has been red-hot this year, is coming off the boil. Prices rose (a still warm) 0.6% m/m, but the annual rate has fallen to 16.5% y/y since peaking at 22.6% in April. More relief here should help broader disinflation given its outsized impact recently. ➡️       Energy prices were also down in August across gasoline, electricity and utilities prices. Relative to a year ago, prices at the pump are down 10%. While the inflation rollercoaster seems largely under control now, it has left prices for a number of goods and services at much higher levels than they were just a few years ago. This is likely one factor constraining consumer sentiment, but importantly, wage growth has now outpaced consumer price inflation for 16 consecutive months and consumer spending overall remains resilient. Following gains of 1.5% and 2.9% ann. in 1Q and 2Q, we are tracking a solid 3.2% gain in real consumer spending for 3Q24. 💡  The #Fed is all but certain to cut interest rates at their next meeting and this report should add to Powell’s pile of “good news”. We continue to expect the Fed will opt to cut by 25 basis points, but the pace and magnitude of the easing cycle thereafter will depend crucially on the Jobs mosaic – where a complex picture with sometimes mixed signals continues to show a broadly healthy economy that is slowing, not stalling. 

Inflation cooled a bit more than expected in May, and CPI Rent (and OER) played its part -- continuing along its predictably slow path downward. Like I've said before, CPI Rent is like an 18-wheeler riding its brakes down a mountain. We know where it's headed, but it just takes a while due to its mechanics (methodology). CPI's Rent of Primary Residence and Owners' Equivalent Rent both cooled slightly to their lowest levels in two years. (Reminder: CPI Rent and OER are both sourced from the same survey of 7k renters/month, NOT homeowners as many commonly/incorrectly believe.) There's a lot of demand for rental housing across the U.S., but even more supply hitting the market -- helping taper rent inflation. So there's no doubt that the 40-year high in new apartment construction plays a big role in cooling inflation, given the rent slowdown's strong correlation to supply + the outsized role of rent on CPI. Rents have slowed down most in the markets building the most new housing. Build, baby, build. #CPI #inflation #housing

The Federal Open Market Committee (FOMC) has strongly signaled that they won’t cut the Federal Funds Rate until September at the earliest, and likely only once in 2025 (unless the employment data shows significant deterioration). One reason for this is the FOMC is quite worried about sharp increases in inflation expectations exhibited by both consumers and businesses. Two charts below show these dynamics. Thoughts: •The top chart shows the median point prediction for the year-over-year inflation rate one year from now from the New York Fed’s Survey of Consumer Expectations (https://lnkd.in/g4Tsdtej). As recently as November, inflation expectations were back to 3%, which was the stable, pre-COVID level. Since then, inflation expectations have surged to 4.79% as of April. We know the culprit: tariffs. •The bottom chart shows the expected change in prices paid over the next 12 months for inputs from the Richmond Fed’s manufacturing survey (https://lnkd.in/gvHt3VQa), with data through May. While May’s reading came down to 6.75% from 8.38% in April (likely due to the China tariff pause), we can again see a sharp increase in inflation expectations that can only be due to one thing: tariffs. •Why do inflation expectations matter? In the FOMC’s mind, inflation expectations can turn into a self-fulfilling prophecy. For example, if firms expect to pay more for inputs, it makes it easier for suppliers to raise prices. While I think inflation expectations are often incorrectly predicted (e.g., consumers in 2022 were expecting 8% inflation over the next year, something that certainly didn’t come to pass), the FOMC gives these data weight in their decisions on the Federal Funds rate. Implication: the impact that tariffs have had on inflation expectations this time around, relative to 2018 and 2019, has been far more pronounced. Such increased expectations make the FOMC less likely to cut interest rates before multiple additional months of CPI, PPI, and PCE data are available (barring a sharp deterioration of the job market). I'll be curious if the ruling of the Reciprocal and Trafficking tariffs as unconstitutional has any effect. #economics #markets #supplychain #ecommerce #freight

Tariff Turbulence averts soft landing The administration has made more than 50 announcements and executive orders on tariffs since inauguration day. Those shifts have whipsawed financial markets and left firms caught in a vicious cycle of panic and paralysis. Measures of economic policy uncertainty have soared to record highs, eclipsing the peak hit during the pandemic. That will take a toll on business investment and big purchases by households. The National Association of Home Builders index plummeted in early May, as foot traffic waned. Home builders are caught in the crosshairs of changes in trade and immigration policy. The mere threat of higher tariffs triggered a surge in imports, notably from China in the fourth snd first quarters. Producers scrambled to get goods into the country ahead of any major tariff announcements, Firms doubled up on those efforts as the rhetoric escalated along with actual tariffs. Disruptions due to the surge in tariffs on China have already occurred. The ports in California that see the bulk of ships from China, have seen business plummet. That is rippling through supply chains and could reveal itself with empty store shelves in late May, early June. A lot of imports were also stored in bonded warehouses in free trade zones. They arrive as an import but are left in limbo until tariffs fall and/or the buyer pays the duties it owes. The drop in tariffs to 30% from 145% may unlock a lot of that inventory at the lower rate. That could speed some imports as they are already here. April inflation, retail sales and production data revealed the imprint of tariffs. Prices of big ticket items started to pick up even as prices for discretionary services - airfares, cruise fares and hotel room raids - eased. Margin compression showed up in the producer price index for the month. Manufacturing activity dropped on the heels of a pull back on vehicle production. Vehicles are being hit hard by tariffs, despite some recent carve outs. The April data represents the proverbial calm before the storm. Prices are poised to rise even as profit margins fall. That contrasts the trade war of 2018-19, when tariffs were lower and almost entirely passed onto consumers. The one-two punch of escalating prices and compression of margins are what makes tariff’s stagflationary. They stoke inflation, while forcing tough layoff decisions. There is no easy choice for a central bank during an episode of stagflation. The only thing we know for sure is that those who stimulate before inflation is tamed find their efforts backfire. Any stimulus to employment is quickly wiped out by a yet another surge in inflation. The risk is even higher if Congress attempts to add significant sweeteners to tax cuts. (We learned very little from the pandemic.) That leaves the Fed on the sidelines. It can’t cut preemptively to ease the blow of tariffs to employment without risking a more pernicious bout of inflation.

Inflation Slower Than Expected as Tariff Effect Remains Mute CPI inflation for May came in softer than market expectations, despite a significant increase in tariffs on most goods since early April. While this is a positive sign for now, we believe it won’t last long in the months ahead. 📈 The fact is: as the U.S. effective tariff rate across all trading partners rose from 2% in March to 7% in May, the prices of imported goods have certainly increased. The key question is whether businesses have been able to absorb these price hikes using inventories built up before the tariffs took effect—and whether they’ve been reluctant to pass those costs on to consumers. ✔️ We think the answer is yes. But once those inventories are depleted, we should expect a sharp increase in prices. That said, it won’t be easy to pinpoint the timing, as consumers are also pulling back on spending, which puts some downward pressure on prices. 📊 Most importantly, we should avoid overreacting to the inflation readings from the past two months, which we believe reflect more noise than trend. If the recent drop in inflation turns out to be a false positive—temporarily boosting confidence and spending—the eventual rise in inflation, once tariffs are passed through and demand rebounds, could be even more pronounced. We don’t expect the Fed to respond to this latest data point in any major way. The bar for a rate cut remains very high as trade uncertainties persist.

It’s CPI #inflation data, which means it’s time to check in on what has been one of this cycle’s most important charts… … and it may not be so important anymore. Though there is plenty of debate remaining on the data and the economy, there is no longer much debate about the path of inflation. July’s #CPI figures affirmed the market’s emerging narrative that #growth – not inflation – represents the key risk to positioning ahead. A few notes on the report: At the highest level, the report had no surprises. Data came in line with investors’ expectations. Underneath the hood, higher prices on “must” have non-discretionary items, such as #shelter and insurance, are starting to crowd out the “nice to have” discretionary items. Prices for items like airfares and food away from home are moving lower. Disinflation has historically been challenging for corporations, who experience lower pricing power as a result. With economic momentum and price growth slowing, we may see macroeconomic conditions more firmly reflecting in Q3 #earnings. Shelter costs are still sticky. We are not concerned about shelter inflation in the medium term or as impacts Fed policy; data related to rents and new tenant applications suggest that shelter price inflation can move lower in the coming year. We are, however, mindful that sticky shelter prices can impact household spending on other items, especially when wage growth is decelerating. What does this mean for the #Fed? The Fed has clearly stated that it needed to see more data in line with recent prints – not better data – in order to justify a cutting cycle to begin in September. We believe this bar is amply met with today’s data. Economic momentum is slowing. For a Fed that is concerned about its balance of risks, and who considers its policy position already tight, it’s appropriate to expect a faster pace of normalization in the coming 12 months. The market is weighing the potential for a 50 basis point cut. Though there is still plenty of time to demonstrate otherwise, we don’t believe that today’s data represents an urgent need to cut 50 basis points in September. Even if data are slowing, the signs we would look for to signal a recession – such as a meaningful rise in jobless claims or deterioration in corporate outlook – are not yet flashing red. 

How do we slay inflation? Housing cost is the most important, and largest, contributor to both household budgets and inflation metrics like CPI and Core PCE. Without a doubt, both rents and home ownership costs have accelerated at a blistering pace since January 2020. As can be seen on the attached graph, since January 2020, CPI has gone up 20.3%. Rents as measured by OER (Owner Equivalent Rent) is up 22.1% - fairly close to CPI. Now, here is where it gets interesting. The Case-Schiller National Index is up 47.2% over the same period. That's 133% more of an increase than CPI. That's astronomical, any way you cut it. We are talking about the single largest real estate market in the world, and it's 133% higher than CPI over a 4 year period. A 47.2% increase!!! How is this possible? It's possible because of government policy that got way out of hand. It all starts with 2008 and the aftermath. What did the Fed do in reaction to 2008? First they flooded the system with equity injections at the big banks as a sign of confidence. That was "only" $700B. Seems like such a small number now compared to all the recent stimuli but back then it was an astronomical number. But what has caused this real estate nightmare was their next big invention: Quantitative Easing (QE). The Fed began to buy Treasuries and MBS all along the yield curve to reduce interest rates and stimulate the real estate market. They did this because housing values dropped about 35% in 2008-09. At the beginning it was a reasonable response to a financial crisis. By October 2016, the Case Shiller Index hit 184, which was the peak value reached in 2006. Job well done. Yet QE continued unabated until 2020, and when the Covid Crisis hit, they went into QE overdrive, which finally blew the roof off the housing values. Why did it continue? A really good question involving human behavior, and the fact that no government employee ever wants to yank the punch bowl from the party. And a lot of people were getting rich. Case-Shiller is now at 316, which is 172% above the peak 2006/2016 value. The reason for housing inflation, 2016 until now, is that interest rates were too low, causing payments to be too low. As you all know, people buy a house with a payment they can afford. The total price is less important than the monthly payment. Then, to pour gasoline onto a roaring flame of house price inflation, government covid stimulus plans poured thousands of dollars into households, which people then rolled into new properties at 3% rates. What a mess. Anyways, I just read this morning that $0 down mortgages are coming back... per Morningstar, a company called United Wholesale Mortgage is offering zero-money-down mortgages for people earning below 80% of a region's median income. They are coupling that with a second mortgage to cover the down payment so people can avoid PMI. Nothing to see. Move along. #fedpolicy #interestrates #riskmanagement

Lately I've seen a lot of takes about our recent spike in inflation, and I think some of them are missing the mark. Let's go back to basics and figure out what really happened. In the simplest example, inflation is the response of prices to the amount of money people have to spend. Imagine if we instantly added a zero to every form of currency in circulation. Most likely, every merchant would just add a zero to their prices. A tenfold increase in the money supply would lead to a corresponding increase in prices, with no change in economic activity. But we know that prices can also respond to changes in supply and demand. All other things equal, an increase in demand raises prices in the short term. All other things equal, a decrease in supply will do the same. So inflation can result from at least three different forces in the economy – monetary policy, demand, and supply. Sometimes monetary policy and demand are grouped together, since monetary policy can affect the supply of credit and thus people's spending power. During the Covid-19 pandemic, the government tried to counteract the downturn in the economy via both monetary and fiscal policy. The Federal Reserve Board expanded the money supply enormously, lowering both short- and long-term interest rates. The federal government provided unprecedented levels of income support. There was more money in people's hands. Yet there was another enormous change that affected supply and demand. Because people were stuck in their homes, a huge amount of consumption shifted from services to goods. There was no way the supply of goods could respond instantaneously, especially with Covid-related drags on supply chains. Then the invasion of Ukraine by Russia made matters worse by restricting the global supplies of fuels and grains. The early manifestations of inflation were primarily in these commodity markets. It surprises me that some economists now attribute this inflation to demand rather than supply. When people have more money, they don't necessarily buy a lot more fuel or grain. The consumption of these items tends to be pretty steady over the economic cycle. Their prices still skyrocketed. Later on, housing became a key driver of inflation. Demand may have contributed to this change. But we also know that supply fell, with existing home sales in 2022 dropping to their lowest level since 2014. New housing starts also dropped sharply in 2022 as rising interest rates made construction more costly. Overall, which factors dominated? The Federal Reserve Bank of San Francisco has an entire line of research breaking down inflation into demand- and supply-driven components. They find a mixed picture throughout the inflationary period (see chart). So if you're going to claim – as some economists have – that one factor or another was dominant, you'd better have a really good explanation for why they're wrong! #inflation #economy [Chart: FRBSF]