Deloitte Economic Update: US Inflation Recedes More Than Expected

What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.

This article originally appeared on Deloitte.

US inflation recedes more than expected

  • US investors were in a celebratory mood last week following release of the government’s report on consumer prices. Inflation was significantly lower than previously expected. In October, consumer prices were up 7.7% from a year earlier, down from 8.2% in the previous month; it was also the lowest annual inflation rate since January 2022. In addition, prices were up 0.4% from the previous month, the same as in September. In the last four months, the month-to-month increase in consumer prices averaged 0.275%. In the previous four months, the increase averaged more than 0.9%. Clearly, inflation is decelerating.

Moreover, when volatile food and energy prices are excluded, core prices were up 6.3% from a year earlier, down from 6.6% in the previous month. Core prices were up 0.3% from the previous month, a relatively low rate. Meanwhile, the category that fueled the initial surge in inflation, durable goods, saw very little inflation. Recall that durable goods prices were up more than 18% from a year earlier back in late 2021. Now, durables prices are up only 4.8% from a year earlier. This reflects declining demand and an easing of supply chain disruption. This indicates that the fundamental factors that first drove inflation are easing. That, in turn, could make the Federal Reserve’s job a bit easier.

Notably, prices of new cars continued to rise rapidly in October, likely reflecting the shortage of semiconductors. Moreover, even as home prices have started to decline, the shelter component of the CPI increased sharply. This component tends to move slowly and with a lag. Thus, there remain significant inflationary pressures in the US economy. Still, the trend is favorable.

In any event, the nearly unambiguously good news on inflation was greeted with enthusiasm in financial markets. In the United States, equity prices soared, with the S&P 500 index up more than 4% shortly after the report was released. Bond yields fell sharply as well. The US dollar declined in value, with the Japanese yen hitting a six-week high. The market reaction reflected a belief that, with inflation coming down more quickly than anticipated, the Federal Reserve will be more likely to pause interest rate normalization in the near future. It also reflects the belief that a Fed pause reduces the likelihood of recession, or at least a deep recession. It is notable that several Fed regional presidents have spoken about pausing the interest rate normalization process.

A Fed indicator points to further reductions in inflation

  • As central banks tighten monetary policy to stifle inflation, the question arises as to when central banks ought to pause and allow the impact of tight monetary policy to take its course. We know from history that monetary tightening works with long and variable lags. Thus, even though inflation remains high, it could be that central banks have already taken sufficient action to suppress inflation. And, if they continue tightening, they might overshoot, thereby creating a deeper downturn than is necessary. In fact, it can be argued that many recessions in history were caused by monetary policy mistakes in which central banks tightened too much for too long. The problem is that we just don’t know. As such, conducting monetary policy is like navigating in the dark. The hope is that there might be an indicator that would let us know when inflation has turned the corner. The Federal Reserve Bank of New York might have such an indicator.

The New York Fed has created an “underlying inflation gauge (UIG)” that is meant to signal when inflation is on the verge of reversing course. The UIG is designed to find the persistent part of inflation. The New York Fed says that “the design of the UIG is based on the idea that movements in underlying inflation are accompanied by related changes in the common persistent component of other economic and financial series. Consequently, we examine a large dataset and apply modern statistical techniques, known as dynamic factor models, to extract a small number of variables that capture the common fluctuations in the series. These summary factors serve as the basis for constructing the UIG.”

The most recent data on underlying inflation suggests that inflation in the United States is turning the corner. The “full-set” version of the UIG has been steadily declining since March. Headline inflation, on the other hand, has only be receding since June. Thus, the UIG was an early indicator that inflation would soon turn the corner. The trend makes sense in that, not only is the Fed tightening monetary policy, but other factors are driving an easing of inflationary pressure. These include a shift in consumer spending behavior away from goods, an easing of supply chain stress, and a decline in oil prices.

The US midterm elections surprise observers

  • For many years, the mantra of some political experts in the United States was, “It’s the economy, stupid.” That is, voters vote their perception of economic security. Thus, given high inflation and the perception of recession risk this year, it was widely expected that the Republicans would do exceptionally well in the recent midterm elections. Moreover, the party that occupies the White House ordinarily sees major losses in midterms of the first term in office. This was true in 1994, 2010, and 2018. The only major exception was the midterm election in 2002, not long after the 9/11 tragedy.

Now, the midterms of 2022 can be added to the short list of exceptions. There are a variety of explanations for the exception. One is that young voters (those under 30) came out to vote in much larger numbers than pollsters had anticipated. Moreover, as expected, they tended to vote overwhelmingly for Democrats.

Although the much-heralded Republican wave failed to materialize, as of this writing we still don’t know who will control both houses of Congress. It seems likely that the Republicans will control the House, although this is likely to be by a very small margin—very different from the wave they expected. In the Senate, the Democrats will retain control of the chamber with the remaining seat in Georgia to be decided on December 6.

What will the outcome mean? Going forward, there will be little chance of significant new legislation if the Democrats lose either or both houses. Instead, expect more regulatory action on the part of the Biden Administration. There are, however, two issues that could be very important.

First, the debt ceiling will soon need to be increased. Republicans have said that they will want some fiscal restraints in exchange for agreeing to raise the debt limit. Democrats say that fiscal policy is already very contractionary and that, regardless of the spending situation, the government’s obligations must be funded. This is a game of chicken. No one really wants to see the government default on its obligations. Financially, this could wreak havoc with asset markets. Politically, a government failure to fully pay Social Security benefits would be perilous for the party perceived as responsible for failing to raise the debt ceiling. Thus, there is reason to expect that something will be done. The question is how?

One possibility is to do it during the lame duck session of the current Congress that remains controlled by Democrats. However, doing this will require the support of some Senate Republicans due to Senate rules. They might prefer to wait in order to extract concessions from the Democrats. If raising the debt ceiling is delayed, then the new Congress must address the issue. With Republicans likely in control of the House by a narrow margin, this means that a small number of members have leverage, thereby potentially creating difficulties. Or, it can be argued, a narrow margin makes it easier to gather up the small number of Republicans willing to raise the debt ceiling without a fight. At the end of the day, it will depend on what the new speaker, likely Kevin McCarthy, is willing to do.

Second, many Republicans in the House, including their leader Kevin McCarthy, have said they want to scale back or halt aid to Ukraine. If they are successful, it would likely have broad geopolitical implications. It could possibly embolden Russian President Putin and weaken US links with its European allies. It would be a sea change in the foreign policy of the Republican Party, which, since the end of World War Two, has been highly internationalist. This would be a reversion to the isolationist role the Republicans had played before World War Two.

Chinese exports decline

  • Exports from and imports into China declined in October from a year earlier. The decline in exports was the first since early in the pandemic. The decline in imports likely reflected weakened demand for exports, the production of which requires substantial imported inputs and commodities. The weakness of exports was due to a weakening of global demand as the global economy decelerates. In part, the decline in exports reflects a shift in global demand away from goods and back to services. Recall that, during the pandemic when people were avoiding social interaction, global demand for goods surged while global demand for services faltered. This helps to fuel an export boom for China. Now, with the pandemic perceived as largely over, demand is shifting back to normal, thereby having a negative impact on Chinese exports.

The weak export data is not especially welcome given that domestic demand in China is already weak. This partly reflects the impact of the zero–COVID-19 policy that constrained consumer social interaction and, consequently, spending. Lately there have been rumors of an impending easing of the government’s COVID-19 policy. These rumors drove increases in asset prices. Yet the government has recently offered mixed signals, reiterating the correctness of its COVID-19 policy and imposing new restrictions in Shenzhen, but also easing some restrictions at the same time. For example, the government will reduce the quarantine period for visitors from seven days to five days.

Meanwhile, one of the key drivers of China’s export prowess in recent decades was massive foreign investment in export-oriented manufacturing. In addition, inbound investment helped to develop a more sophisticated domestic market. Thus, at the China International Import Expo in Shanghai, China’s leader said that the country will continue to welcome and encourage inbound foreign investment.

In addition, the country will seek membership in the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP), a free trade agreement of Pacific rim nations. The CPTPP was originally meant to be a partnership that included the United States, but the United States withdrew in 2017 and has indicated it will not return. Thus, China is attempting to play a dominant role in trade rules in the region. It is not clear if the other members of the CPTPP will be amenable to China’s entry.

Although China appears to be encouraging more inbound foreign investment, the retention of COVID-19 restrictions makes it difficult for foreign business leaders to travel to China, thereby limiting their ability to make agreements. Moreover, there is anecdotal evidence that many global companies are attempting to reduce exposure to China by diversifying supply chains, if only as an insurance policy against future unexpected disruptions.

Retail trade in Europe surprises on the upside

  • The volume of retail trade in the Eurozone (that is, retail sales adjusted for inflation) increased in September and appears to have stabilized in the past two months, despite a decline in real purchasing power of consumers. The EU reports that, in September, retail sales volume was up 0.4% from the previous month, having been flat from July to August and having mostly declined in the preceding four months. Also, retail sales volume was down 0.6% from a year earlier.

Spending volume on automotive fuel was down. On the other hand, real spending on nonfood, nonfuel goods increased by 1% from the previous month. Real spending by mail order or internet was up a strong 2.6%. By country, real retail sales increased from the previous month by 0.9% in Germany, 0.2% in France, 0.2% in Spain, 1.3% in Netherlands, and 1.1% in Belgium; and declined by 0.1% in Italy.

The rebound in retail spending could be a temporary anomaly. Real incomes are declining, consumer confidence has plummeted, and the economy is set to move toward recession as the European Central Bank continues to tighten monetary policy. On the other hand, some governments are offering sizable subsidies to households to offset the impact of elevated energy prices. Plus, oil and gas prices have lately fallen. These factors are helpful to retail sales.