The price is high

Quick takes:

• CPI remains elevated in January
• Weak consumer sentiment prevails
• Fed walking a fine line
• More inflation data this week
• CRE remains well positioned

The seemingly inexorable rise of inflation continued in January. The headline consumer price index (CPI) increased by 7.5% on a year-over-year basis while core CPI grew by 6% on year-over-year basis. Both represented their highest respective growth rates in four decades. Increases occurred broadly across a variety of goods, especially core commodities (common goods available throughout the world). Through January, headline CPI has grown for 20 consecutive months, the longest spell since July 2008 when the energy bubble drove inflation upward.

What’s the story?

Largely, the narrative on inflation remains unchanged. Strong aggregate demand (AD) continues to exceed aggregate supply (AS), pushing prices upward. But why? The short answer is the resurgent pandemic. On the AD side of the ledger, consumers retain the ability to spend via excess savings and relatively strong wage increases. But the resurgent pandemic better supports demand for goods (which get safely consumed at home) versus services (which generally get consumed elsewhere), even though services spending continues to recover. Meanwhile on the AS side, the resurgent pandemic continues to disrupt production and distribution of goods. People called out sick in record numbers in January, disrupting production. Moreover, China retains its zero COVID policy, shutting down factories, ports, and sometimes even whole cities to stop outbreaks, especially leading up to the Winter Olympics. The monthly trend in CPI largely reflects this COVID resurgence. The monthly growth rate started to accelerate last spring when the combination of warmer weather, vaccination, and fiscal stimulus combined to drive demand upward. CPI then cooled a bit in the summer as COVID case levels decreased. But the Delta wave in late summer followed by the Omicron wave this winter is causing a reacceleration.

Monthly inflation

The murky crystal ball

Inflation remains among the most challenging components of economics to forecast because the pandemic continues to defy many experts’ expectations. That said, most experts believe that we are entering a more stable phase of the pandemic (if not the endemic phase) as the world obtains greater immunity (or at least resistance).  If so (and we stress if), a few things should occur. First, consumers should continue to shift back toward services spending and away from goods, which should help ease some of the pressures on the goods supply chain. Second, demand growth should slow due to fiscal restraint (fading fiscal stimulus) plus tighter monetary policy. Third, fewer COVID-related disruptions should enable the global supply chain to ramp up again, spurring growth in AS. Lastly, base effects should work in reverse beginning in the second quarter: once year-over-year changes are calculated versus higher prices, year-over-year inflation should slow. But all these underlying causes should take time to fully occur. Consequently, we still expect inflation to remain somewhat elevated by the end of the year, even as it backs off from its current torrid pace. And because of structural shortages for some inputs to production (e.g. labor, semiconductors, energy) inflation will likely settle into a range this business cycle above the range from the previous business cycle. Though we caution that as consumers shift from goods to services, the labor shortage could strain services production, putting pressure on services inflation even as goods inflation cools. 

Consumer sentiment and the Fed

With inflation remaining elevated and the highest recorded COVID case numbers, consumers sentiment declined in February, falling to its lowest level since 2012. Yet low consumer sentiment is not restraining consumer activity yet. Consumers have taken higher prices in stride and continued to spend. That raises the stakes for the Fed as it tries to deftly raise rates to prevent overheating without raising them too much and causing a recession. We expect AD growth to slow which should ease some pressure on prices, but higher rates should factor into that slowing process. Therefore, the Fed will have to hit a moving target. Every previous iteration of higher inflation (which we loosely define as year-over-year CPI above 5% on a multi-month basis) over the last 50 years ultimately resulted in a recession, even if higher interest rates only played part of that process. 

| What we are watching this week |

More inflation data should reflect the dynamic discussed above. Both the headline and core producer price indexes (PPI) for January should show slowing versus December on a year-over-year basis but remain near their record-high growth rates. January import prices should show a bounce back after a decline in December. Similarly, advance retail sales for January should also show a rebound after an outsized decline in December. Housing starts and permits likely edged up in January.

| What it means for CRE |

Commercial real estate (CRE) remains well positioned to weather elevated inflation and higher interest rates. It has acquitted itself well over multiple business cycles going back decades. Leases retain the ability to adjust to inflationary pressures by marking-to-market quickly with short-term leases or because of inflationary clauses embedded in longer-term leases. CRE has also shown a weak, often negative correlation with interest rates. The main factor for the performance of CRE remains the macroeconomy. We retain a cautiously optimistic outlook for economic growth in the short to medium term which should support CRE space market fundamentals, cap rates, and valuations. 

| Thought of the week |

Americans are projected to have spent roughly $24 billion on Valentine’s Day in 2022.