U.S. Economic Outlook

Inflation and the economy on the move

Inflation is back! Or is it? The slightly above consensus headline CPI reading of 2.6% year-on-year for March was taken remarkably calmly by markets and commentators.[1] U.S. Federal Reserve (Fed) officials did all they could to massage the message: this is transitory inflation, they argued. For economists, however, the latest report remains intriguing. It may serve as a preview of what is about to happen in coming months.

The March CPI reading was driven by soaring energy prices and is a classic example of so-called statistical base effects: One year ago, in March 2020 as the pandemic hit, U.S. economic activity was cut to the bare minimum. With less demand for energy, prices started to fall. In March 2020 the energy price index declined to 199.57 from 211.72 in March 2019, a -5.7% drop, providing a low base for prices now.[2] But the 13.2% jump in the energy price index in March this year shows that something more than base effects is at play.

Chart 1: Oil as a major driver for energy prices

202104_U.S. Economic Outlook_Charts_1_300DPI.png

Sources: Energy Information Administration, Chicago Mercantile Exchange, Bureau of Labor Statistics and Haver Analytics as of April 2021

Expectations of broad economic re-opening and the accompanying surge in demand for gasoline, jet-fuel and so on, is likely to have supported oil prices (and therefore energy prices). The West-Texas-Intermediate (WTI) crude oil price even surpassed its March 2020 level (Chart 1). It is also striking that most of the slump in crude oil and energy prices a year ago took place in April and May, not in March. This implies that the biggest impact from base effects is still ahead of us. If the March CPI reading was just the beginning, what can we expect? A simple extrapolation of historical inflation trends indicates that CPI prices could indeed rise above 3% in the coming months (Chart 2).

Chart 2: Approximating the impact from base effects

202104_U.S. Economic Outlook_Charts_2_300DPI.png

Sources: Bureau of Labor Statistics and Haver Analytics as of April 2021

However, the exact formation and pass through of prices is highly complex and any simple extrapolation implicitly neglects changing demand patterns. But nevertheless, the extrapolation may well serve as an indication of what can be expected in coming months.

It is also true that even a headline CPI figure somewhat above 3% might not move the Fed from its complacent, accommodative stance. Year-on-year base-effects are transitory by definition and excess demand generated by economic re-opening and fiscal stimulus checks should normalize before too long. And during the last several weeks Fed officials have clearly expressed their view that this kind of transitional inflation should be tolerated. The Fed would only feel compelled to act if it were to see what might be called the real deal: inflation generated by economic growth and higher wage growth resulting from tightening labor markets.

What might therefore bother the Fed is the pace at which the recovery appears to be accelerating. The recent exceptionally strong economic data on consumption and hiring has surpassed even the boldest predictions. Retail sales for March exceeded pre-pandemic levels by more than 17% as in-store shopping bounced back strongly while internet shopping remained at a high level.

Chart 3: Retail sales surpass pre-pandemic levels by more than 17%

202104_U.S. Economic Outlook_Charts_3_300DPI.png

Sources: Census Bureau and Haver Analytics as of April 2021

The speed with which the labor markets are recovering is also quite impressive. The so-called Beveridge[3] curve suggests that more jobs remain available in this crisis compared to other cycles (Chart 4). A different take would be that the virus and the measures to fight it are continuing to keep people away from work. As vaccinations progress at a record speed, the obstacles to work are likely to fade and employment levels may bounce back quickly.

Chart 4: The Beveridge curve indicates a fast labor-market recovery

202104_U.S. Economic Outlook_Charts_4_300DPI.png

Sources: Bureau of Labor Statistics, Haver Analytics and DWS Investment GmbH as of April 2021

This might mean that the economy rises faster than expected to the Fed's goals of maximum employment and toward the goal of stable inflation above 2%. And recently we saw a clear change in tone. In a widely anticipated interview TV interview, Fed Chair Jerome Powell struck a much more bullish tone than before on the economic recovery.[4] He said a near-term rate hike was "highly unlikely" – a somewhat softer tone than the previous framing of "don't think about thinking"[5]. He now sees the economy at an "inflection point," with "very strong" job growth likely in the months ahead. And while he did not provide a clear timeframe, he considered how monetary support could be reduced. Tapering of asset purchases, he said, will most likely start "well before" rates are lifted.[6] His colleague, Fed St. Louis President James Bullard, went further, hinting that tapering talks could be warranted once 75% of the population are vaccinated.[7] Of course, the relationship between vaccinations and the state of the economy is unclear but he could have chosen his words wisely. Most projections suggest that the 75% vaccine threshold might be reached sometime in July – and the prominent Jackson Hole meeting takes place in August. This meeting has often been pivotal for monetary policy. We could well imagine that the tapering discussion will step up significantly.

Overview: key economic indicators

2021

 

 

 

2022

 

 

 

Q1F**

Q2F

Q3F

Q4F

Q1F

Q2F

Q3

Q4F

GDP (% qoq, annualized)

3.2

6.6

4.9

4.1

3.6

2.4

2.8

4.1

Core inflation (% yoy)*

1.4

1.6

1.7

2.0

2.0

2.1

2.1

2.2

Headline inflation (% yoy)*

1.6

1.7

1.8

2.1

2.1

2.2

2.2

2.3

Unemployment rate (%) (EOP)

6.8

6.0

5.5

5.0

5.0

4.7

4.4

4.2

Fiscal balance (% of GDP) (EOP)

/

/

/

-14.6

/

/

/

-4.5

Federal funds rate (%)

0.0-0.25

0.0-0.25

0.0-0.25

0.0-0.25

0.0-0.25

0.0-0.25

0.0-0.25

0.0-0.25

*PCE Price Index
** Forecast

 

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All opinions and claims are based upon data on 4/19/21 and may not come to pass. This information is subject to change at any time, based upon economic, market and other considerations and should not be construed as a recommendation. Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect. Source: DWS Investment GmbH

082248_1 (04/2021)

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