Financial market commentary in the week ahead will likely center around the question of inflation. The headlines speak for themselves. CPI inflation jumped to 6.2% year-over-year in October, its highest reading in 31 years.

In a world where short political sound bites often drown out rational economic analysis, the reasons for this surge are usually over-simplified, with commentators focusing on just one of many factors ranging across pandemic-related supply-chain disruptions, over-easy monetary policy, excessive fiscal stimulus, over-regulation, not enough workers, hardline OPEC producers and corporations exerting near-monopoly power.

However, while many of these issues have contributed to the inflation surge, the best way to understand it and to predict where inflation goes from here is to examine the major contributors to the inflation surge on a sector-by-sector basis. This exercise suggests that most of the current inflation pressures are indeed transitory and should ease in the year ahead.

The October CPI report showed broadly rising inflation. However, there were some particular areas that made an outsized contribution to the 6.2% gain. The most obvious of these was energy, where a 30% increase over the past year contributed 2.2 percentage points of the overall 6.2% rise.

This is largely due to strong gains in oil prices, with West Texas Intermediate Crude more than doubling over the past year from $39.40 per barrel in October 2020 to $81.48 in October 2021. This, in turn, reflects a faster rebound in global oil demand than supply. The OPEC+ group is, so far, being quite disciplined in only slowly ramping up production. However, at over $80 a barrel, U.S. shale oil should be very profitable and we expect to see U.S. and non-OPEC production in general, increase sharply in the year ahead.

A similar story can be told surrounding natural gas prices, where Henry Hub spot prices also more than doubled to $5.51 per million BTU in October 2021 from $2.39 a year earlier. Again, high prices should encourage more supply.

The important implication of this is that, based on forecasts from the Energy Information Agency, we expect that energy prices will fall by 7.0% over the next year, subtracting 0.5% from CPI. If every other number in the October 2022 CPI was the same as in the 2021 report, the swing in energy prices alone would cut inflation from 6.2% year over year to 3.5%.

The motor vehicle sector is another important area of higher inflation recently that may actually reduce inflation in the year ahead. In October, new vehicle prices were up 9.8% year-over-year and used vehicle prices were up 26.4% year-over-year.

This clearly reflects a lack of inventory, with vehicles on dealer lots plummeting to under 40 days of sales by the end of September, compared to an average of 64 days of sales over the past decade. The lack of inventory is widely reported to be due to the global shortage of computer chips, which helped cut U.S. auto production by 13.7% year-over-year in September.

However, automakers will likely find ways of increasing production in the months ahead. One positive sign was a 3.0% month-over-month increase in auto manufacturing employment in October and analysts expect a strong gain in motor vehicle output in the October industrial production release, due out on Tuesday. If vehicle production is able to outpace demand and lead to a recovery in inventories in the year ahead, then new vehicle prices should rise much more slowly and used car prices should decline. Over the next year, a 2% rise in new vehicle prices and a 5% decline in used vehicle prices would turn a 1.2 percentage point addition to year-over-year CPI inflation over the past year into a 0.1 percentage point subtraction.

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