Inflation's Next Chapter

Where We've Been—And Where We're (Maybe) Going

Note: I was on two podcasts this week! I spoke with Alex Chausovsky for the Discerning Distributor podcast on Commodity and Input Prices and with Luca Monk for the Closingbell podcast on Recession Risk and the US Job Market. Give them both a listen!

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Inflation is too high, and the Federal Reserve’s singleminded focus on containing inflation means that each Consumer Price Index (CPI) release carries tremendous importance. That’s what made yesterday’s CPI data especially disconcerting—monthly inflation was 0.1%, much higher than the negative print expected by forecasters. Critically, the divergence was due to higher-than-expected core inflation—mostly from housing rental prices—more than offsetting the anticipated drop in gasoline prices.

The Federal Reserve will freely admit to being unable to meaningful shape the path of food and energy prices. During the early pandemic, when supply chains broke and demand for various goods surged, an argument could be made that several other categories of goods—motor vehicles, furniture, hotels, and more—joined food and energy as prices untethered from the general influence of monetary policy. But even throughout this, there was a core of cyclically-sensitive prices (mostly core services, which includes housing) that remained subdued throughout 2020 and much of 2021.

Now, the opposite situation is emerging. Acyclical prices driven by localized demand and supply mismatches are having less of an influence on inflation—due largely to factors outside of monetary policy—and cyclical prices driven by broad-based economic conditions are having more of an influence on inflation—though these likely reflect demand dynamics from several months ago due to how the CPI incorporates housing prices.

The two big questions are:

• How much immaculate disinflation can we get from acyclical prices?

• When (or if) can we expect intentional disinflation from the tightening of monetary policy?

Where We’ve Been

In the immediate aftermath of the Russian invasion of Ukraine, an already-stressed global energy market was sent into a tailspin. In the months since, the US has initiated an unprecedented release of oil from the Strategic Petroleum Reserve (SPR) to supplement domestic production and relieve the stress on prices. Protecting the US from the economic fallout of a geopolitical confrontation with a nation like Russia is arguably the SPR’s raison d'être, and it has successfully contributed to the alleviation of energy price increases over the last 2 months. But two other factors have arguably had just as important an effect on energy costs. The first is the large negative pull on demand from the widespread COVID lockdowns throughout China, which now affect about 65 million people. The second is the alleviation of refinery capacity shortages that plagued the immediate post-invasion energy market. Alongside the drop in oil prices, we’ve seen a massive drop in refinery margins—the cost to convert crude oil into products like gasoline—as refineries work to catch up with (lower) global demand levels. Refiners are overproducing gasoline in an effort to rebuild stocks of diesel and other distillates, which remain in shorter supply with elevated margins.

To make a long story short, drops in gasoline prices are finally pulling monthly inflation down—making them the largest contributor to today’s immaculate disinflation. Energy’s contribution to year-on-year inflation sits at about 1.75%, the lowest level since the start of this year (though still extremely high by pre-pandemic standards). And falling gas prices will likely have effects outside of the energy sector—a paper by Conflitti, Cristina, and Matteo Luciani (2017) at the Federal Reserve shows a short-term direct passthrough onto core inflation (through transportation services and other items directly related to oil prices) and a small longer-term common passthrough (through macroeconomic conditions).

Still, global energy markets remain extremely fragile by historic standards and the drops in gas prices have masked equally-important increases in natural gas prices (and thereby electricity prices, more than 1/3 of which is generated from natural gas in America). The US Energy Information Administration expects residential electricity prices to rise 7.5% through this calendar year and another 3.3% in 2023, and they don’t expect any drop in natural gas prices until supply picks up in early-to-mid 2023. The SPR release is scheduled to conclude at the end of October, and marginal oil production will be handed back to a US oil industry whose output remains 1 Million barrels per day below pre-pandemic levels. Geopolitical risks from the European energy crisis, lockdowns in China, and the Russian invasion will all keep energy markets on edge for the time being—so it remains to be seen how much more immaculate disinflation we can get from gasoline and other energy commodities.

Where We’re Going