The main topic of 2022 was inflation. The end of the year is approaching and the question remains whether the peak of inflation is really behind us. The objective of this article will be to determine if the inflationary pressures are over and especially to know what the impacts of this are in the long term.
What does peak inflation mean?
Peak inflation is the level from which inflation slows down and falls. During the first half of 2022, we had a sharp rise in inflation. The increase is not really the question but above all the speed of this increase. Speed is an important issue since it involves how much growth can absorb it.
Since June, we have had a slowdown and a decline in inflation. Despite all this, it is important to remember that it is just as difficult to time an inflation peak as it is to time a high or low point on the financial markets.
We can see that inflation started to fall when commodities also fell. A boost in commodity prices helps to alleviate some of the inflation. This can be seen in the following graph, which puts the inflation figure in parallel with the variation in oil prices.
What are the indicators for measuring inflation?
We have three possible measures:
- The CPI (Consumer price index) – Consumer price index
- PCE (Personal consumer expenditure)
- The PPI (Producer price index) – Producer price index
The ICC is the indicator most watched by the public. It measures the change in price of a basket of goods and services. The data is taken from a survey of thousands of consumers.
Unlike CPI, the PCE is based on surveys of companies and not consumers. Like the CPI, it measures the variation of a basket of goods and services.
For those who don’t know, the PCE is the tool used by the FED (American central bank). At least, it is based on the “core PCE” version. That is to say, it will take the PCE data but without including the food and energy part which are more volatile.
The last measure remains the PPI. It is different from the CPI and the PCE because it takes into account the business inputs that will make the goods and services.
We can deduce from the graphs that in all three cases we have had a slowdown in inflation since July 2022..
The case of used cars
The used car indicator is a very useful tool to identify the strength and speed of the rise in inflation as well as the opposite effect. We can see thanks to the following graph that we have a sharp drop in used cars unlike 2021. We have gone from a price growth of + 54.7% to – 10.4%.
The most tenacious components
When measuring inflation, we have factors that are more difficult to slow down than others. This is the case for inflation in services, for example.
We can see from the graph below that goods are helping to slow inflation in the forecast, but that of services persists.
In the service part, the most tenacious factor remains the rents. Throughout 2022, we’ve had central banks hike rates. Consequently, rate hikes do not encourage buying real estate, and people tend to rent. The other effect remains that the rise in rates also implies an increase in cost for owners with variable rates. This also applies to those who need to renew their mortgage. Therefore, to meet this cost increase, some will increase rents.
Here is an overview of rent inflation (in green) and in blue the “core CPI” without rents.
Shelter = Rent
The effect of money supply and inflation
The three major factors that impact business cycles are:
- The growth
- Inflation
- Cash
The notion of liquidity is important for inflation because the more liquidity we have in the financial system, the more this money is available to be used in the economy. Consequently, this can generate both growth and inflation.
Take the example of the COVID crisis. In 2020, the central banks made injections of money in order to revive growth. We can see that during this period, there was a rather impressive increase in savings. This is explained by the fact that households were more anxious about the future and preferred to save than to consume these liquidities.
We can see on the following graph the increase in the personal savings rate during 2020 and 2021.
However, it can also be seen that in 2021 there has been a sharp drop in the savings rate. This means that the savings money was used in the economy, which also contributed to the rise in inflation.
Once the savings money is consumed, what is left? Consuming on a credit card. This is where you can see the switch between falling savings and record levels of credit card consumption (see chart below). The total consumption of savings followed by the rise in credit card levels helped fuel and keep inflation high.
The Fed’s restrictive monetary policy
The FED has been pursuing its restrictive policy since 2022 in order to bring inflation back to a target rate of 2%. A restrictive policy means that there is less and less liquidity available in the financial system. Even if the effects take time, this can have an impact on slowing inflation in the same way that the injections have had an impact on the rises.
The Fed can’t fix the supply chain problems (the supply side of the inflation), but it can touch the side that it has caused itself via injections in the past.
On the other hand, increasing interest rates so much (restrictive policy) will have an impact on credit card rates and commercial banks. Therefore, the record level of credit card use is not sustainable over time.
The case of the wage-price spiral
We know that a good part of the inflation is due to an increase in the money supply during 2020-2021, not to mention supply and geopolitical problems. Until then, the American central bank has reversed its accommodating monetary policy towards restrictive throughout 2022. The effects are beginning to be felt in particular on the prices of certain goods, but wages continue to have adjustments.
The graph below shows that real income growth has accelerated by 3.5% over the past 3 months.
As long as we maintain wage adjustments and a very tight job market, that will maintain the standard of living. This also means that it is difficult to bring inflation completely down to the target rate. The tight job market is pushing to adjust salary increases. This is why the theory of the recession to bring down inflation towards the target rate of 2% seems just as possible. Why? A recession involves attacking the job market, and therefore an increase in unemployment.
The consequences of rising inflation
Each rise in inflation has its own consequences. Generally, growth and inflation go hand in hand. That is to say that an acceleration of growth implies inflation and vice versa. In this case, we have a slowdown in growth because the potential for growth is just as limited with so much debt.
For a good part of 2022, i.e. the first half of the year, growth was high enough to support the gradual increases in key rates.
The main question now is whether the hikes will further impact growth. It is obviously weaker than at the beginning of 2022, and the GDP forecasts for the US in 2023 are much weaker. We need growth to support high rates.
As I said earlier, a restrictive Fed means that there is less liquidity in the system. Therefore, as the economy is addicted to cash, this affects forward growth.
Worries in 2022 were mainly about inflation, those in 2023 will be more about growth. Everything will be played on the pivot level of the FED, between pivoting too early or too late. Pivoting too soon would mean taking the risk of reigniting the flame of inflation and of pivoting a recession too late.
Conclusion
For the time being, many factors suggest that peak inflation is behind us for this economic cycle. The restrictive monetary policy contributes to the decline of certain goods but it cannot solve supply problems. And as long as monetary policy does not affect wages, this will keep the inflation rate well above the central bank’s target rate.
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