Following a solid jobs report last week, investors this week will turn their attention to inflation, which, to say the least, has been more of a problem this year. We expect this Friday’s CPI report to show a 0.6% increase in prices overall and a 0.4% gain in prices excluding food and energy. On a year-over-year basis, we are looking for headline inflation to fall from 8.2% to 8.1% and for core inflation to drop from 6.1% to 5.7%.
Economists and the Federal Reserve may take some comfort in the small easing in core inflation. However, the report should also show the biggest gap between year-over-year headline and core inflation seen since 2008, with food prices up roughly 9.4% and energy prices up 33.4% relative to a year ago. This is important, as it implies a much tougher inflation problem for lower-income households, could result in lower consumer spending on other basic goods and services and, by pummeling consumer confidence, increases the risk of recessionary psychology taking hold.
For the most part, high food and energy prices reflect the results of the pandemic, the fiscal policy response to the pandemic and the war in Ukraine. As these shocks to the global economy fade and high prices increasingly spur production and stifle demand, both food and energy prices should ease. However, there continues to be a risk that the Federal Reserve feels obliged to aggressively tighten to speed the decline in inflation, potentially tipping the economy into a recession to fight an inflation problem that was going to fade anyway. Either way, investors should hesitate to make a long-term bet on rising or even sustained inflation at these levels.
The Outlook For Food And Energy Inflation
In recent decades, whenever the United States has seen a spike in inflation, the most likely culprit has been oil. And, indeed, crude oil prices are high, with the spot price of a barrel of West Texas Intermediate Crude trading for $101.78 in April, $109.55 in May and $114.96 on Memorial Day, up 73% year-over-year.
In part, this reflects the reality that global energy demand recovered from the pandemic more rapidly than OPEC anticipated and OPEC was slow to raise production quotas. However, some OPEC members are also struggling to meet their quotas due to conflicts and mismanagement. In addition, Russia’s invasion of Ukraine and the resulting sanctions have significantly reduced Russia’s output. Last year, Russia accounted for 10.8 million of the world’s daily output of 95.6 million barrels. The U.S. energy information administration currently expects Russian output to sink to 9.2 million barrels by 2023.
Today’s high crude oil prices should result in stronger production elsewhere in the world in the rest of 2022 and beyond. However, for U.S. consumers, there is another problem.
There are 42 gallons in a barrel of crude oil, so the May WTI price of $109.55 equates to $2.61 per gallon. However, the average U.S. price of a gallon of gasoline in May was $4.55, or $1.94 more. This spread, which reflects refiners’ margins, retail markups and taxes, was the highest on record and 41 cents higher than a year earlier. This, in turn, reflects lower-than-normal gasoline inventories and very limited U.S. and global refinery capacity, a situation that has been exacerbated by the war in Ukraine and resulting sanctions on Russia.
As in the case of crude oil production, very high refiner margins should, in time, increase supply and reduce demand. However, there is no reason to believe that gasoline prices will fall quickly or sharply from here in the absence of a global recession.
Turning to food, today’s very high inflation reflects multiple issues but probably starts with the impact of pandemic assistance on consumer spending. While the pandemic triggered a very sharp but brief recession, federal government fiscal aid has been very generous under both the Trump and Biden administrations. Three rounds of stimulus checks, in April 2020, December 2020 and March 2021, amounted to a total of $3,200 per adult with further money for dependents, which obviously was more significant for lower income households. Consumers also benefited from enhanced unemployment benefits, enhancements to the child tax credit and enhancements to earned income tax credits. Partly as a result of this, real consumer spending on food jumped by 7.6% in 2020 and a further 3.2% in 2021. This was an extraordinary surge in demand in an industry that has always run on tight margins and just-in-time inventories. While real food spending has now fallen in five of the last six months, the shock to supply chains across food production and distribution has yet to fade.
Food production has also been impacted by a series of disasters. A global avian flu has resulted in a surge in chicken, turkey and egg prices. The Ukraine war has slowed the exports of Russian and Ukrainian grain and boosted the price of fertilizers. And drought conditions and a labor shortage are contributing to an increase in U.S. fruit and vegetable prices.