2022 Was A Scorcher, Inflation-Wise. 2023 Won’t Be.

2022 Was A Scorcher, Inflation-Wise. 2023 Won’t Be.
Luke Suddards

about 1 year ago6 mins

  • After a red-hot 2022, US Inflation is likely to cool significantly in 2023, falling to within the 3%-4% range.

  • Supply chains are normalizing; prices are sliding across some key inflation components, the effects of Fed tightening are beginning to show, and a softening labor market could erase some wage pressures.

  • But certain risks to the outlook remain and that means we could see inflation linger longer.

After a red-hot 2022, US Inflation is likely to cool significantly in 2023, falling to within the 3%-4% range.

Supply chains are normalizing; prices are sliding across some key inflation components, the effects of Fed tightening are beginning to show, and a softening labor market could erase some wage pressures.

But certain risks to the outlook remain and that means we could see inflation linger longer.

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2022 has been the year of red-hot inflation. In the US it hit a wallet-melting 9.1% in June, a level not seen in over 40 years. Since then price pressures have been sliding lower. Many (myself included) now believe we’ve seen peak inflation – and that 2023 will be the year of significant disinflation, pushing price pressures back down into the 3%-4% range by the end of next year. These are the factors that are likely to drive the cooldown.

1. Global supply chains

Supply chains took a hammering during the Covid era, as factories were shut down and as labor shortages caused severe backlogs and bottlenecks to build up in the system. All that friction led to a significant increase in costs. I remember seeing videos of thousands of container ships out in the ocean, idly waiting for their turn to reach port to unload their cargo. It really was unprecedented times. Fast-forward to today, and the supply chain picture looks a lot more healthy, with delivery times much faster and shipping costs much lower. The Federal Reserve’s (the Fed’s) Global Supply Chain Pressure Index is a handy indicator to use as a health check on supply chains. It combines data on shipping costs, delivery times, and backlogs from manufacturing firms across seven interconnected economies: China, the euro area, Japan, South Korea, Taiwan, the United Kingdom, and the United States. The index has dropped by 77% since the beginning of the year.

The Fed’s Global Supply Chain Pressure index. Sources: Federal Reserve & Piper Sandler.
The Fed’s Global Supply Chain Pressure index. Sources: Federal Reserve & Piper Sandler.

2. Key inflation components

The war in Ukraine drove a sharp spike in energy prices this year. The invasion and resulting sanctions led to disruptions in Russia’s oil supply. Shrunken supply and steady demand pushed prices higher. Energy prices have since fallen, and investors now seem to have adjusted to the situation, with even the recent Russian oil price cap not sparking a major market reaction. And with the slowing global economy likely to bring down oil demand, investors anticipate that its prices will remain lower too. Oil is currently trading around $76 a barrel, compared to the 2022 highs of about $130, and if it stays at this level, it will have a negative impact on inflation next year. Some people expect that the reopening of China’s economy could lead to a pop higher in the oil price, but it would have to average more than $96 a barrel next year to drive any growth in overall inflation.

The war also drove food prices higher. Russia and Ukraine account for more than 30% of global wheat exports, so the war had an impact on this supply without other countries able to plug the hole. However, a Black Sea grain deal has helped ease these supply pressures, and has already driven prices lower.

Covid brought about some pricing anomalies, for example in automobile sales. Factory shutdowns caused a shortage of the semiconductor chips that are required to manufacture new cars, which led to fewer cars being produced – and with more people buying cars to avoid public transport, that sent the price of used vehicles through the roof. Prices accelerated by 45% in June 2021, compared to the year before, but now those increases are very much in neutral. In November, used cars were just 2% higher compared to the year before.

The pandemic also created some inventory headaches for retailers, who over-ordered to compensate for potential supply chain snarls and overestimated demand too. Now they’re saddled with too much stock – which means discounts, another drag on inflation. A recent KPMG survey showed that 56% of retail executives expect to have too much inventory after the holiday period.

Finally, there’s shelter, which tracks rental prices. This is the heaviest component, accounting for around a third of the total inflation rate – and its prices appear to be peaking. Data from Zillow and Apartment List, which have been known to accurately forecast shelter costs by up to 12 months, and they’ve been pointing to lower market prices for future rental contracts. And that cooldown is likely to show up in US CPI shelter costs in early 2023.

CPI rent, Zillow Rent Index, and Apartment List Rent Estimates. Sources: Zillow, Apartment List, the US Bureau of Labor Statistics, and Piper Sandler.
CPI rent, Zillow Rent Index, and Apartment List Rent Estimates. Sources: Zillow, Apartment List, the US Bureau of Labor Statistics, and Piper Sandler.

3. The money supply

The famous economist Milton Friedman once said: “inflation is always and everywhere a monetary phenomenon.” What he meant is that increases in the money supply always lead to inflation. With the Fed buying government bonds in a strategy aimed at lowering yields known as “quantitative easing”, and with the government handing out multiple rounds of stimulus checks during the Covid crisis, there was a surge in the money supply. It wasn’t the only reason for the spike in inflation, but it was – as it’s been before – an important driver.

But now the Covid crisis has waned, and the Fed’s keenly focused on bringing down inflation, primarily with a series of aggressive interest rate hikes. It’s also using quantitative tightening, rather than easing: in other words, it’s letting those government bonds fall off the Fed’s balance sheet as they come to maturity, rather than reinvesting them. And those things – referred to as “monetary tightening” – are sucking money out of the system, and that suggests inflation should slide. The chart below shows headline CPI pushed back 16 months (blue line) with M2 money supply leading by 16 months (yellow line). Since the two usually move in tandem, this suggests that CPI could fall sharply in the next 16 months, following in the footsteps of money supply.

M2 money supply year-on-year changes in percent and US CPI year-on-year changes in percent. Source: Morgan Stanley
M2 money supply year-on-year changes in percent and US CPI year-on-year changes in percent. Source: Morgan Stanley

But the impact to inflation won’t happen right away: interest rate hikes take time to work through the real economy. The Fed has tightened aggressively this year, so this should have a strong effect throughout 2023.

4. The job market

With slowing growth in the working age population and a surge of early retirements since the Covid era, there’s been a shrinking in the pool of labor supply. But there are still some signs of a softening taking place. Job openings and quit rates have both been falling more recently, indicating fading demand for workers. We’ve also seen lots of companies, particularly in tech, cutting headcount or placing freezes on new hires. What's more the Atlanta Federal Reserve's wage growth tracker looks to have peaked at 6.7% compared to the previous year as the latest reading comes in at 6.4% compared to last year. This combined with the other factors suggests it's unlikely we'll see a wage-price spiral exacerbating inflation even more.

Atlanta Federal Reserve year-on-year wage growth tracker in percent. Sources: Bank of America & Atlanta Federal Reserve
Atlanta Federal Reserve year-on-year wage growth tracker in percent. Sources: Bank of America & Atlanta Federal Reserve

What, if anything, could keep inflation from falling?

It’s possible that the US job market won’t soften enough to successfully bring down wage pressures. And it’s possible that the war in Ukraine will see another escalation, resulting in a further spike in oil and food prices. What’s more, some are warning that China’s full reopening could cause a global inflationary wave. However, I see a more muted global impact, with consumer and government spending delivering much of its boost to the domestic economy, as China puts its own economy first, post-lockdowns. So, it’s worth keeping these risks on your radar…

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