Lord Abbett: What The April CPI Jump Might Mean For Fed Policy
While the larger than expected increase in the U.S. consumer price index took markets by surprise, the U.S. Federal Reserve likely will remain focused on labor costs.
Consumer prices in April rose much more than expected according to a U.S. Bureau of Labor Statistics report released May 12, with the headline consumer price index (CPI) rising 0.8% versus expectations of a 0.2% increase, and core CPI, which excludes food and energy prices, up 0.9% versus 0.3%.
As much as the larger than expected numbers took Wall Street by surprise, we believe they are still consistent with the U.S. Federal Reserve’s (Fed) views that a “level” adjustment higher is to be expected as the economy progresses towards full reopening and that base effects1 will result in a temporary surge above the central bank’s 2% inflation target.
Figure 1. April Sees a Bigger-than-Expected Increase in Consumer Prices
Percent change in components of the monthly U.S. consumer price index (CPI), January 2009-April 2021
Source: U.S. Bureau of Labor Statistics. Data compiled May 12, 2021. YOY=Year-over-year. Core CPI excludes food and energy prices. For illustrative purposes only.
Larger than expected price increases in April were caused by huge increases in a couple of items: used cars (+10%!) and airline fares (+10.2%), and small ones in many others. While rent inflation is picking up as the economy recovers, it is still tracking slightly below the pre-shutdown trend. This is important because rents are one of the most cyclical components of inflation and are a large enough component of the consumption basket to influence headline outcomes.
Watching the Trends
A little over a year into the pandemic, relative prices have adjusted as would be expected; very strong demand for core consumer commodities has caused inflation to accelerate sharply for those items and much weaker spending on core consumer services has caused that portion of core inflation to decelerate. That is clear from two-year trends of annualized inflation rates that smooth out base effects from the combination of the sharp price declines that took place during the shutdown in March–April 2020 and adjustments higher taking place now.
Figure 2. Commodity, Service Inflation Trends Have Diverge
Two-year annualized percentage changes in the monthly U.S. consumer price index (CPI) and indicated components of the index, January 2015–April 2021
Source: U.S. Bureau of Labor Statistics. Data compiled May 12, 2021. For illustrative purposes only.
As shown above, core goods price inflation (blue-green line) has moved sharply higher as household income has risen due to large fiscal transfers and shortages for certain items have developed along the supply chain. But this has been accompanied by lower inflation in core services (blue line) as consumers have avoided spending on things that could expose them to infection by virtue of their being consumed in social settings. Overall, however, CPI increases, whether headline (green line) or core (yellow-green line) are still in line with the pre-COVID trend.
Fed Policy Implications
The pandemic is an unprecedented event and the price adjustments that take place as the economy grows into its “new normal” are, to some extent, unpredictable. From the above, it seems likely that core service inflation will pick up as more people are vaccinated and infection risk recedes while core goods price inflation will slow as supply increases and spending adjusts to a lower trend level.
But the kind of inflation the Fed cares about won’t pick up unless labor costs increase and keep accelerating. Where the labor market settles as growth slows later his year and spending patterns normalize is what the Fed will be watching closely as it determines when to begin the process of removing accommodation. or now, in our view, the central bank need not change its guidance.