Don’t Worry, Core Inflation dropped. It’s only Food and Energy costs that are getting worse.

Bad News: Headline Inflation up 8.5% year over year
Good News: Core inflation (ex food and energy) is up ‘only’ 6.5%
From here forward, the year-to-year inflation comparisons start to get easier
Our seemingly insatiable demand for ‘stuff’ is finally easing and that will help
But we are not out of the woods yet: food and energy inflation could linger longer
Supply Chains will take years to adapt. Policy can make it easy or hard. (Bet on hard.)

Markets choose to focus on the good news as stocks and bonds rallied under the presumption that the Fed can now be less aggressive in raising interest rates, but make no mistake. Inflation is still a problem. It just won’t look quite as bad as the prior few months and that takes a little pressure off the Fed. As we move forward, it is important to remember that the Fed focuses on ‘core’ inflation. That is inflation excluding food and energy. The reason for that is that the Fed does not want to overreact to food and energy inflation as typically, these are temporary and flip flop back and forth. (This is clear in the energy inflation on the chart below.)

Inflation isn’t going back to 2% in the near term, but the data should be looking better in coming months. There are several reasons for that.

The ‘base effect’, which simply means that comparisons get easier. Looking at the chart above inflation really started to kick up in the first quarter of 2021. Now that we are headed into the second quarter, the comparisons are with months that were already elevated last year, particularly energy. The implication is that, over the coming months, the headline inflation data will show a declining trend. We suspect that will further calm some of the recent inflation hysteria.
Our demand for ‘stuff’ appears to be waning and other than automobiles, inventory levels have recovered. Last week we highlighted the sudden weakness in freight demand in the trucking industry. That is caused by two things: First, the Covid spike in demand is finally ending and second, we have increased our trucking fleet by about 10% from two years ago. This is called the bullwhip effect. We have increased supply to meet a temporary spike in demand. That ultimately causes overcapacity. The next step is for that overcapacity to begin to cause deflationary pressures. We could be seeing the start of that in the trucking industry, but it will not be confined to the trucking industry.

For the most part, inventories are have returned to normal. If we look at aggregate retail inventories (red line), they are still struggling to get back to pre-pandemic levels. That is in sharp contrast to wholesale inventories (green line) and retail inventories, excluding the auto industry (blue line), which have fully recovered to the pre-pandemic trendline. Autos appear to be the primary remaining problem, but that will come around eventually too. For the most part inventories are now in good shape, so the demand pressure created by re-stocking is receding.

Energy and Food are Wildcards

This is where things get less predictable. Without some meaningful demand destruction, energy can be an ongoing problem. We were already somewhat short energy before the Ukraine war due to chronic underinvestment. In our rush to go green in the long term, we failed to invest in the transition in the short term. We were already headed in the direction of paying a stiff price for that miscalculation and the Ukraine situation simply accelerated what was probably already coming.

Even if we were to have a sudden outbreak of world peace, Ukraine complicates the energy situation. The days of relying on ‘unfriendly’ countries for critical goods is in the process if ending around the world. That means that

the West needs to become more self-sufficient for the energy needs today and
supply chains need to adapt to a rapidly changing geopolitical world.

Neither will be cheap or easy and both would benefit from coherent policy in that direction, which so far has been lacking, not only here, but in the EU.

Food has also been headed in an inflationary direction as drought has affected some of the primary bread baskets of the world, particularly the U.S. and Brazil. Now we are potentially losing another key agricultural area – Ukraine.

There is nothing like a strong crop to get food inflation back into line, but with fertilizer costs through the roof, it will take a perfect growing season to get any real relief and that is a long shot. This is an area where world peace could allow Ukraine to once again be very productive and help ease the coming food shortage.

The bottom line is that energy inflation could ‘self correct’ in the face of a recession (demand destruction), but food inflation is giving all the appearances of becoming a more persistent problem.

A Confederacy of Dunces (With apologies to John Kennedy Toole)

The extraordinary lack of economic acumen that politicians demonstrate never ceases to amaze. Not long ago, it was the Build Back Better plan. Whatever opinion you might have about the worthiness of the programs, pumping that much money into a developing inflationary mess would only make the current inflation that much worse. Thank God for Senator Manchin, who seems be one of the few that paid attention in economics class.

This week, the Biden administration, at the behest of Republican Senators Grasserly and Ernst, is allowing more ethanol in fuels this summer (up to 15%) as a way to ease the pain of oil prices. What apparently wasn’t considered is that ethanol is derived from corn. In case they hadn’t noticed, food inflation happens to be as damaging, if not more damaging, than fuel inflation. Fertilizer prices are through the roof because production requires natural gas. As a result, soy planting is expected to exceed corn planting for the first time in over 30 years. Why? Because soy requires substantially less fertilizer than corn. With continuing droughts in the U.S. and Brazil, already threatening crops this year, we want to use more corn to make our fuel cheaper!

The simple economics lesson that must be learned is this. If Demand outstrips supply, prices rise and there are two possible ways supply and demand can be brought back into balance: 1) Increase supply, or 2) reduce demand. We have chosen to increase the supply of fuel, by decreasing the supply of food. Brilliant!