Boston - As inflation concerns have heated up in recent weeks — with Consumer Price Index (CPI) increases over the past two months exceeding most expectations — people in the non-transitory camp certainly have more to cheer about. But we think the debate over transitory or non-transitory can be misleading, because it frames inflation in a binary way that does not shed light on all the various shorter- and longer-term forces at work.
Consider how financial markets are reacting. Rates at the short end of the yield curve are way up, not just in the U.S., but globally with the pulling forward of central bank expectations for rate hikes to combat inflation. Over the same period, however, the long end of the curve has been rallying.
Longer-term inflation expectations aren't really that high. Five years from now, the CPI is pegged at 2.3%, as measured by the market's pricing of five-year Treasury Inflation-Protected Securities (TIPS) five years forward. The U.S. Federal Reserve's preferred measure of inflation, the Personal Consumption Expenditures price index (PCE), is generally around 30 basis points (bps) lower, putting five-year inflation expectations at about 2%.
No one has precisely defined "non-transitory," but these aren't the kinds of signals we would expect if inflation really was viewed as out of control. Similar evidence can be seen in the Fed's gradual course of tightening (which still doesn't involve raising rates), the new highs that the stock market seems to be hitting each day and ongoing easy credit conditions.
A look at the technical factors driving inflation shows a mixed picture. Car prices have dominated the news, and the supply constraints and production bottlenecks are very real. They have also had an outsized impact on inflation measures. But car prices have advanced so far, they have nowhere to go but down, and are bound to have a downward pressure on inflation in the future.
Cars have accelerated inflation, but are due for a slowdown
Sources: Eaton Vance, Bureau of Labor Statistics, Bloomberg, as of November 15, 2021. Percentage point contribution to core CPI.
Conversely, the shelter component of CPI has been a laggard, but as of February, prices began to pick up (in the CPI, shelter is determined by rents and "owner equivalent rents," not the strong increases in housing prices). The cost of shelter soared 0.5% in October, its biggest increase in 20 years; going forward it is likely to continue to put upward pressure on CPI.
To us, the most interesting issue is whether the labor supply has really changed, post-COVID. Several aspects point to a secular, permanent shift:
- A lot of people over 55 who left the labor force aren't coming back; they are effectively retired.
- Women who dropped out of the labor force at the start of the pandemic — in many cases because they took responsibility for child care — have not returned in the same numbers.
- Attitudes toward work have changed. The once-in-a-lifetime shock of the pandemic has led many to reevaluate their priorities, and how work, money and status fit in with other life pursuits. Not everyone, of course, but perhaps enough to tip the scales in the labor supply equation.
Trying to balance out the technical forces we have touched upon is an imperfect business: Inflation works in ways we don't understand, and doesn't fit neatly into "transitory" or "non-transitory." For example, inflation commentary has broken out of the financial press to become a big topic now in popular media. This could feed back into inflation expectations in any number of ways, such as giving workers a justification to push for further wage increases.
Bottom line: The simple binary of "transitory or not" sheds little light on inflationary forces, which the market still believes will subside over the next couple of years. We are inclined to believe that, too... at least until the facts on the ground — including the labor market — start to point otherwise.