Although core CPI inflation remains muted at 1.6% in July, the surge in prices last month specifically could be the start of a more significant rebound, as the added costs and ongoing supply constraints stemming
from the pandemic and physical distancing offset the disinflationary impact from weak demand. The prices of the goods and services that fell most sharply at the start of the pandemic – like air fares, hotel room rates
and motor vehicle insurance rates – are now rebounding, while low inventories explain the surge in motor vehicle prices. With unit labour costs up sharply in the second quarter, money supply soaring, and inflation
expectations unusually resilient given the extent of the economic downturn, there are plenty of other reasons to suspect that the balance of risks for inflation lie predominantly to the upside.
- Although core CPI inflation remains muted at 1.6% in July, the surge in prices last month specifically could be the start of a more significant rebound, as the added costs and ongoing supply constraints stemming from the pandemic and physical distancing offset the disinflationary impact from weak demand. The prices of the goods and services that fell most sharply at the start of the pandemic – like air fares, hotel room rates and motor vehicle insurance rates – are now rebounding, while low inventories explain the surge in motor vehicle prices. With unit labour costs up sharply in the second quarter, money supply soaring, and inflation expectations unusually resilient given the extent of the economic downturn, there are plenty of other reasons to suspect that the balance of risks for inflation lie predominantly to the upside.
- Output and activity indicators show that manufacturing is still lagging in its recovery, but the low level of inventories points to some catch-up over the coming months.
- Consumption indicators illustrate that the expiry of enhanced unemployment payments is not yet weighing on the high frequency spending indicators.
- Investment indicators reveal a V-shaped recovery in housing activity.
- External trade indicators suggest that both exports and imports will rebound strongly.
- Labour indicators disclose that most of the unemployed are on temporary layoff rather than permanent job losers.
- Inflation indicators show a marked rebound in July, mainly due to a partial reversal of the earlier slump in the prices of the most-affected goods and services.
- Financial market indicators reveal a small rebound in long-term Treasury yields, which is still probably too modest to seriously worry Fed officials.
Chart 1: CPI Inflation (%)
- Although the number of cases is still elevated, the drop-off in the coronavirus infection rate leaves us increasingly positive about the likely rebound in activity in the third quarter (2). Our forecast that GDP will increase by 25% annualised looks a little pessimistic now, particularly in light of the further solid gains in retail sales and industrial production in July, i.e. when the infection rate was still rising (3).
- The near-33% annualised slump in second-quarter GDP was principally due to a big collapse in consumption, concentrated in services (4). With retail sales rebounding sharply even before the end of the second quarter, a significant recovery in consumption in the third quarter is all but guaranteed.
- The latest activity surveys point to a marked rebound, although the manufacturing sector now appears to be lagging non-manufacturing (5). Manufacturing output was still well below its pre-pandemic level in July which, along with the ongoing contraction in mining, explains the lingering weakness in industrial production (6). Manufacturers may have struggled to restart production due to supply chain issues but, with inventories now looking leaner than they were pre-pandemic, we expect production to continue ramping up over the next few months (7).
Chart 2: Coronavirus Infections & Deaths (7d ma, 000s)
Chart 3: Real GDP
Chart 4: Contribut’n to Annualised GDP Growth (% pts)
Chart 5: ISM Survey-Based Activity Indices
Chart 6: Industrial Production (2012 = 100)
Chart 7: Business Inventory-To-Sales Ratio (%)
Sources: Refinitiv, Johns Hopkins, Capital Economics
- The recovery in consumption slowed in July, with retail sales rising by a more modest 1.2%. But that was to be expected given that sales are now above their pre-pandemic levels, with control group sales much higher than in February (8). The recovery in spending at bars & restaurants as well as clothing retailers is lagging but, despite the spike in coronavirus cases last month, continued to rise (9). As the number of new infections recedes again, high-frequency indicators of discretionary consumption have begun to pick up over early August (10).
- Admittedly, motor vehicle sales remain below pre-pandemic levels, but that is principally due to weaker commercial sales (11).
- The expiry of $600 weekly Federal unemployment insurance benefit at the end of July will deliver a big hit to personal incomes, which have been running well above February levels (12). Even so, consumers still have scope to run down their savings, which remain unusually elevated (13).
Chart 8: Retail Sales (Feb ’20 = 100)
Chart 9: Retail Sales (Feb ’20 = 100)
Chart 10: High-Freq. Consumption Indicators (%y/y)
Chart 11: Light Vehicle Sales (Mn, Annualised)
Chart 12: Chg in Personal Income Since Feb. ($trn)
Chart 13: Personal Saving (% of Disposable Income)
Sources: Refinitiv, OpenTable, TSA, STR, Capital Economics
- Although Business investment fell sharply in the second quarter, the decline was less severe than during the financial crisis (14). The monthly durable goods figures confirm that a rebound was already underway in May and June (15), with the latest surveys pointing to further gains ahead (16).
- The collapse in mining investment, driven by a slump in global oil prices, is now largely over and, with global oil prices rebounding, drilling activity is likely to pick up again in the coming months (17).
- With housing demand remaining strong, residential investment is experiencing a V-shaped recovery (18). Housing starts recovered to nearly 1.5 million annualised in July. While that number is just shy of the cyclical peak reached at the start of this year, the latter was distorted by the unseasonably mild weather this winter.
- Both residential and business investment will continue to be supported by loose financial conditions, with mortgage rates and corporate bond yields falling to record lows (19).
Chart 14: Business Investment (%y/y)
Chart 15: Non-Def. Capital Goods Ex-Air. ($bn)
Chart 16: ISM New Orders & Non-Def Cap. Gds. Orders
Chart 17: Crude Oil Price & Drilling Rigs
Chart 18: Homebuilder Confidence & Housing Starts
Chart 19: Corp Bond Yield & Mortgage Rates (%)
- Trade in both directions rebounded in June (20), driven in large part by the restarting of global supply chains, particularly in the autos sector (21). In percentage terms, exports remain further below pre-virus levels, with imports being supported by a quick rebound in consumer and capital goods imports (22).
- The latest ISM survey-based measures of import and export orders are consistent with a sharp rebound in trade in both directions (23 & 24). While trade in goods appears to be bouncing back quickly, the continued outright ban on most travel is holding back services trade.
- Finally, the renewed weakness in the dollar has mostly just reversed the strengthening seen in the initial stages of the pandemic, with the trade-weighted index little changed from its level a year ago. Still, that still suggests the dollar will not be a drag on exports, as it has been in recent years (25).
Chart 20: Real Goods Exports & Imports ($bn)
Chart 21: Real Autos Exports & Imports ($bn)
Chart 22: Change in Real Trade (%, Feb. – Jun.)
Chart 23: ISM Mfg. Export Orders & Exports
Chart 24: ISM Mfg Import Orders & Imports
Chart 25: Trade-Weighted Dollar & Exports (% y/y)
Sources: Refinitiv, Census Bureau
- Non-farm employment increased by an additional 1.7 million in July, which illustrates that the economy was resilient to the recent upsurge in coronavirus cases. Nevertheless, employment was still 12.9 million below its pre-pandemic February level – meaning that only 40% of the lost jobs have been recovered (26),
- The leisure sector, which includes accommodation and food services, remains the hardest hit (27). Employment in accommodation and food services fell by around 7 million – or 50% – during the lockdowns and has since rebounded by about four million. Even other sectors hit hard by lockdowns, like retail, did not experience declines of anything close to that magnitude (28).
- The unemployment rate fell back to 10.2% in July, which represents a sharp decline from the peak of near-15% at the height of the lockdowns (29). Looking at the breakdown, even four months after the pandemic struck there have been surprisingly few permanent job losers (30). The vast majority of the unemployed are still on temporary layoff from their jobs, which leaves us hopeful that the unemployment rate will continue to fall over the coming months. Finally, initial jobless claims have begun to grind lower again in recent weeks, but remain unusually elevated (31).
Chart 26: Non-Farm Payroll Employment (Mn)
Chart 27: Chg in Non-Farm Payroll Emp’t (Feb – Jul, %)
Chart 28: Employment (Million)
Chart 29: Unemployment Rate (%)
Chart 30: Unemployment Rate by Reason (%)
Chart 31: Weekly Initial Jobless Claims (000s)
- The resurgence in inflation in July could be the start of a more significant rebound, as the added costs and ongoing supply constraints stemming from the pandemic and physical distancing offset the disinflationary impact from weak demand (32). Admittedly, the rebound in retail gasoline prices appears to have faded in recent weeks, but the prices of other goods and services are becoming a source of concern (33).
- The inflation rate for food at home remains elevated and prices for restaurant meals are now rising at an accelerating pace too (34). The latter is very different to what happened in the aftermath of the financial crisis. Back then, high unemployment drove down labour costs but, in this crisis, physical distancing requirements are pushing costs higher.
- The initial drop in core inflation when the pandemic struck was mainly due to sharp declines in a few of the most-affected components. But those price declines are now being reversed, with the prospect of more increases in the coming months (35). At the same time, low inventory is driving used vehicle prices higher (36) and even wireless communications prices – a source of deflation in recent years – are suddenly spiking higher (37).
Chart 32: CPI Inflation (%)
Chart 33: Gasoline Prices ($ Per Gallon)
Chart 34: CPI Food Prices (%y/y)
Chart 35: CPI Selected Components (%y/y)
Chart 36: Used Vehicle Price Indices
Chart 37: CPI Wireless Communications Prices (%y/y)
- Producer price inflation remains unusually low, even after excluding food and energy (38). Nevertheless, the surge in unit labour costs is a potential concern since it points to a marked acceleration in core CPI inflation (39). The trade-weighted dollar has been trending lower in recent months, but the rate of decline is still muted, so any resulting inflationary pressure from higher import prices should be modest (40).
- The unprecedented surge in M2 money growth is another potential inflationary concern, but the relationship between money and price inflation has never been particularly strong (41). In this case, the surge in money was largely driven by the Fed’s asset purchases in the early stages of the pandemic, so money growth should slow now that the Fed has dialled back the pace of those purchases.
- Bond market breakeven inflation compensation rates continue to rebound, as markets factor in the rising odds that the Fed will adopt an average inflation target soon (42). Household inflation expectations have also been trending higher, which is not what we normally see during a recession (43).
Chart 38: Producer Prices (%y/y)
Chart 39: Unit Labour Costs & Core CPI Inflation
Chart 40: Trade-Weighted Dollar & Import Prices (%y/y)
Chart 41: M2 Money & Core CPI Inflation
Chart 42: Breakeven Inflation Compensation (%)
Chart 43: Household Inflation Expectations (%)
- The recent uptick in the 10-year Treasury yield probably isn’t enough to worry Fed officials (44). They can take comfort from the fact that the breakdown shows the uptick is principally due to a less negative term premium rather than a rise in interest rate expectations (45). Nevertheless, to the extent the rise in the term premium reflects market concerns about the unprecedented debt issuance by the Treasury, Fed officials might still want to intervene to prevent an even bigger rise in yields – either by expanding their Treasury securities purchases or even by trying to cap yields explicitly. Fed funds rate expectations remain unusually low, but markets are no longer anticipating the adoption of negative rates (46).
- The S&P 500 continues to rebound, bolstered by hopes of an imminent vaccine and the recent drop-off in the infection rate (47). But the S&P’s performance has also been bolstered by a few tech giants, with broader equity indices still down since the start of this year (48).
- After rising sharply in the opening months if this year, the trade-weighted dollar has fallen back and is now close to unchanged form where it was 12 months ago (49).
Chart 44: Treasury Yields (%)
Chart 45: Breakdown of 10-Yr Treasury Yield (%)
Chart 46: Fed Funds Rate Expectations – Dec ‘21 (%)
Chart 47: S&P 500 Index
Chart 48: S&P 500 & Russell 2000 Indices (Jan 1st = 100)
Chart 49: Broad Trade-Weighted Dollar Index
Paul Ashworth, Chief US Economist, firstname.lastname@example.org
Andrew Hunter, Senior US Economist, email@example.com
Michael Pearce, Senior US Economist, +1 646 583 3163, firstname.lastname@example.org