Breaking down the latest CPI number

Inflation has continued to grab the headlines in recent weeks as more advanced economies globally are facing some of the highest price increases over the past 30 or 40 years. When we think about inflation, though, it is important to distinguish between frictional and cyclical inflation. The distinction between the two types of inflation is critical for central banks in determining the right policy action and for how the global economy is likely to evolve from here.

Frictional inflation is driven by more temporary issues such as the current supply chain and Covid-related disruptions and which we believe is the main source of the excess inflation which is currently being experienced in the US, the Euro area and the UK. Cyclical inflation, on the other hand, is a different type of inflation which is more permanent and stickier in nature and which is normally experienced when the economy recovers and there is more demand than what the supply can handle. If the majority of the excess inflation being experienced at the moment was to be attributed to cyclical inflation, then central banks would definitely be behind the curve and as such would be expected to engage in significant policy tightening, with the risk of either causing a recession, or having to wait a number of years to gradually bring it down over time.

If we were to have a closer look at the US inflation numbers over the past couple of months, it is evident that there was a spike in the data since the last quarter of last year, from the mid-single digit levels registered in the third quarter of 2021, to the 7.5% reading registered earlier this year. This coincided with the emergence of the Omicron variant and more specifically the resumption of supply disruptions, particularly out of China which continues to adopt a zero-covid tolerance policy. This resulted in the closure of, and suspension of operations, at a number of major ports, with consequent disruptions in the distribution chain. A positive development in this respect was the recent approval by China of Pfizer’s Covid treatment pill which could signal a shift away from a zero-case strategy towards one which gives more importance to protecting economic growth.

When we examine the components that have driven the latest surge in US headline inflation to its highest level since 1982, it is evident that the largest contribution came from increases in energy prices which is partly to blame for the fear of an escalation in tensions between Russia and Ukraine. On the contrary, when excluding the volatile items of food and energy, the inflation picture looks much more benign with a slowdown in motor vehicle prices (both for new and used cars) and no acceleration in rents, offset by a surprise rise in airfares. However, the latter component is considered extremely volatile and may reflect the release of restrictive measures imposed on airline travel over the prior months.

Other data out of the US shows that the percentage of consumption expenditure out of disposable income is now back to pre-pandemic levels, in the region of 90%, meaning that individuals are not expected to significantly alter their spending patterns going forward. Moreover, it is also worth pointing out that even social benefits are now normalizing towards pre-pandemic levels, leaving little room for a spike in consumption. Finally, wage increases are also expected to abate as discouraged workers have started to decrease, signaling an increase in jobseekers which should prove supportive in stabilizing wage inflation.

These observations all seem to confirm that most of the increase in prices experienced lately is frictional in nature and that inflation could subside notably over the course of the year. This could come as a notable relief for the market, with some analysts having already rushed to price-in five to seven rate hikes in the US for this year only.

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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