Energy and Food Prices to Help the Core Inflation Battle?
Bottom line: Lower raw material food and energy prices have yet to feedthrough fully and thus to reduce CPI food and energy. But the likelihood is that this feed-through will occur increasingly and this should help U.S. and EZ headline CPI inflation fall further in 2023 and possibly more broadly. Indeed, it could also dampen core inflation pressures, as short term inflation expectations are curtailed and in turn this restrains profiteering from companies and wage setting behavior.
Figure 1: Key Energy Prices Rise and Fall (26 April 2021 = 100)
Source: Bloomberg/Continuum Economics
Raw Material Energy and Food Prices Falling
While it is ever clearer that the surge in energy prices after the start of the Ukraine war is reversing, it is perhaps not appreciated just how much this has been given the market focus on oil prices. WTI has come off the peak seen in June 2022, but remains higher than the $55 in April 2021. The volatility of natural gas and coal has been even greater (Figure 1), with U.S./EZ natural gas prices now lower than the outbreak of the war in Ukraine. This all bodes well for direct oil and other energy and electricity prices in CPI baskets and this should continue to come through in the coming months. This has already started to be noticeable in the U.S. and EZ energy CPI baskets (-6.4% and 2.5% Yr/Yr respectively) that is now below headline Yr/Yr inflation and thus dragging inflation numbers lower.
Meanwhile, food prices at a raw material level have also fallen, as shown by FAO food prices Index (Figure 2). The impact on CPI food price inflation in the U.S. and EZ is less noticeable and currently stand at 9.2% and 13.6% respectively, though they are now off their peak. CPI food inflation is more complex than energy inflation. Firstly, transforming raw material food into end products can involve energy intensive processing and then transportation, as well as labor costs. Lower energy prices can now feedthrough to help reduce food prices, especially in Northern Europe where greenhouse production in late 2022 was curtailed due to sky high natural gas prices for heating. Transport costs worldwide are also easing, with supply chain pressures having eased noticeably versus 2021/22. The second issue that has boosted CPI food prices has been local droughts, which Europe suffered from last year. High gas prices and the European drought is one of the reasons that EZ food price inflation has been higher than the U.S. The weather prospects for summer 2023 are uncertain, but water levels in some European reservoirs are low and where temperatures last month were unusually high. This will likely slow the scale of the fall in EZ CPI food price inflation rather than stop the decline. Overall, we see CPI food price inflation continuing to fall Yr/Yr in the U.S. and EZ and could swing towards being less of an inflationary influence on headlines CPI. Indeed, the sharp fall in FAO food prices in 2008 fed through with a lag to help CPI food price baskets to fall to zero (Figure 2) in the U.S and EZ in late 2008 and early 2009 respectively.
Figure 2: FAO Food Price Index and U.S./EZ CPI Food Price Inflation (% Yr/Yr)
Source: FAO
Part of the reason for our forecasts of lower headline inflation in U.S. and EZ for 2023 in the March Outlook (here), comes from the projection that the fall in raw material energy and food prices will feedthrough more into CPI baskets and food and energy will switch to being less of a boost to inflation and in energy’s case should still subtract from Yr/Yr inflation rates. The focus if anything has now switched to core inflation, with headline inflation having already fallen below core in the U.S. Can a slowdown in food and energy prices help to reduce core inflation pressure?
The answer is yes. Food and energy price inflation helped to drive up headline inflation in 2021 and 2022 and has led to companies increasing profit margins more generally. But with food and energy price rises having markedly undermined spending power, especially for discretionary items, we think this will soon sap pricing power (here for our EZ analysis on this issue). Lower food and energy prices should impact household short-term inflation expectations, which are now coming down and will likely see companies more restrained generally on increasing prices. Additionally, slower food and energy prices can feedthrough to wage setting behaviour via short-term inflation expectations and inter-related decreased pressure for high wage inflation. However, wage setting is also a function of the change in demand and supply of labor and the tightness of the labor market. The U.S. is seeing an easing of vacancies, but most labor market indicators point to a still tight labor market going into what should be only a borderline recession. We have highlighted our concern that U.S. wage inflation will not come down enough to be consistent with a 2% Fed core PCE inflation target and we feel that the Fed will struggle to get from 3% to 2% inflation. In the EZ, we see the labor market situation being less tight than the U.S., while labor supply has actually improved more than the U.S. since COVID and has risen above the pre COVID trend of late. We continue to feel that ECB concerns over 2nd round wage increases are overdone and wage inflation should be consistent with the ECB inflation target going into 2024.
Figure 3: FAO Food Price Index and China Food Price Inflation (% Yr/Yr)
Source: FAO
Meanwhile, China CPI food price inflation is already a low 2.4% Yr/Yr and is set to fall further. The 2008 decline in FAO food inflation fed through to produce negative readings for China CPI food prices in 2009 (Figure 3). China’s low headline CPI trajectory (0.7% Yr/Yr) is in sharp contrast to the U.S. and EZ picture, but we feel that this reflects that the disinflationary impact of the 2022 zero COVID policies that have fed through with a lag. The switch to reopening should mean that inflation picks up in H2 2023 and we forecast 2.1% for 2023 (here) and Chinese authorities will be comfortable with inflation outcomes in the 2-3% area.