U.S. Inflation: Is it still not the time to "not worry"?

Although last week's U.S. non-farm payrolls "made a mess," there is still a "flaw" in the speculation about dollar easing—inflation expectations. In June, U.S. inflation was overall below expectations, but some components have already shown clear signs of inflationary pressure. "One wave has not settled, another rises," at the end of July, Trump once again raised U.S. tariffs in a new round of tariff negotiations. So how should we interpret the inflation path under the chain reaction of tariffs?

From the completeness of the analysis, all economic shocks are actually dual-sided, because the economy itself is a self-balancing negative feedback system. Taking inflation shocks as an example, generally speaking, on one hand, shocks will certainly exert pressure on price increases; but on the other hand, the price increases brought about by external shocks will suppress demand, which in turn actually limits the transmission of inflation.

We analyze and track the current U.S. inflation from three dimensions: first is the historical dimension; second is how to track U.S. inflation pressure currently; finally, we believe it is important to note that inflation and inflation data may not be the same thing. We are not worried about the "inflation data" in the short term, but rather about the stubbornness of U.S. inflation after the Federal Reserve resumes rate cuts.

First, looking back at history, the answers given by historical experience are often "a girl dressed up by others." The market tends to compare the current situation with the oil shocks and stagflation of the 1970s, but we believe there may be details worth further analysis behind this: the impact of tariffs mainly has two aspects, one is the direct increase in prices (price), and the other is the supply chain shock (quantity) and secondary effects (such as growth and exchange rates). These two dimensions correspond to different historical experiences: a more intuitive example of the former is the taxation of goods in domestic production or circulation, such as the value-added tax reforms common in developed countries; the extreme example of the latter is the shock caused by the oil embargo in the 1970s, which led to severe supply shortages.

1970s Oil Crisis: The supply disruption caused by the oil embargo had a greater and more troublesome impact on inflation. The gap caused by supply shortages, if new sources of supply cannot be found, can only objectively control inflation by reducing demand, allowing price and quantity to reach equilibrium at a lower level. This process is bound to be "painful," and if the policy is not resolute enough, inflation will appear exceptionally stubborn.

However, the persistently loose monetary policy before the early 1970s led to inflation expectations, compounded by the weak discipline of U.S. monetary policy at that time. To stabilize the economy in coordination with the White House, the Federal Reserve did not raise interest rates thoroughly, and quickly cut rates before inflation had fallen, which, although led to a brief economic recovery, also brought about an upward trend in the inflation center and inflation expectations, laying the groundwork for repeated price fluctuations. With the outbreak of the second oil crisis and renewed control on the supply side, inflation became even more "unmanageable."

The experience of tax increases can refer to the history of Japan and the UK:

Japan's value-added tax (VAT) was raised (against the backdrop of loose monetary policy). Reviewing history, Japan has undergone three rounds of VAT adjustments (in 1997, 2014, and 2019), raising the VAT rate from 3% to 10%, providing rich reference cases for our study of the persistence of price shocks. It can be seen that after Japan's three VAT increases, prices responded immediately, and the year-on-year growth rate of CPI significantly rose in the short term.

However, at the same time, the demand side was also significantly affected. The price increases brought about by the rising tax rate greatly weakened consumers' purchasing power, leading to a sharp decline in wholesale and retail sales in Japan, with residents' actual consumption expenditure declining and maintaining at a low level. This somewhat offset the external price increases, and Japan's CPI began to decline about three months after the tax was imposed.

The UK's VAT increase (against the backdrop of tight monetary policy). In January 2011, the UK raised the VAT from 17.5% to 20%, leading to a sudden intensification of inflation, which was already on the rise. Although the Bank of England viewed it as a temporary shock, there were concerns that rising inflation expectations could lead to more persistent inflation. There were basically two opposing views within the UK; one side believed that the Bank of England should take significant interest rate hikes, or it would lose the chance to curb inflation, while others argued that the UK economy's recovery was far from stable, and that current rate hikes were premature. Ultimately, the Bank of England chose to keep interest rates unchanged, and as real spending slowed due to the VAT increase, inflation soon peaked and began to decline.

The current tariffs may fall somewhere between the two scenarios mentioned above. On one hand, although Trump raised tariffs to the highest level since 1933 (18.6%), there are currently no signs of supply shortages, and there is no insurmountable supply-demand gap: Most non-US economies have chosen to "soften," and there has been no severe domestic product shortages as a result. As the world's largest consumer country, non-US countries, especially emerging economies, still cannot escape their dependence on exports to the US. On the other hand, the impact of tariffs on domestic prices in the US will still be greater than that of general domestic tax increases. For the US, adjustments in the global supply chain will be more flexible than simply shifting from domestic sales to exports, making it easier to transmit to end consumption; additionally, the significant depreciation of the dollar exacerbates inflation.

It is undeniable that most of the tariffs will ultimately be borne by US businesses and residents. But this is a "time-for-space" game: If the pace is not well controlled, it will indeed bring short-term inflationary pressure; however, if the pace is well controlled, with price transmission dispersed and time extended, a slow price increase presents a different scenario—provided that the US can maintain a continued slowdown in wage growth, while not being overly aggressive in interest rate cuts that lead to significant credit expansion. In the short term, the United States is staggering along the narrowest tightrope ("soft landing"), characterized by a relatively controllable transmission rhythm of inflation. However, how the White House and the Federal Reserve continuously adjust their policy mix and pace will be crucial; any "left foot-right foot" dissonance could lead to recession or stagflation.

Secondly, how to comprehensively and timely assess the impact of tariffs on inflation? Tracking changes in inflation data this year may be more difficult than ever, as federal budget cuts and layoffs have resulted in a shortage of personnel for data collection, significantly increasing the workload and estimation ratios, which has amplified data volatility to some extent, leading to reduced precision and accuracy.

In this context, it is particularly important to use multiple-dimensional indicators to assist in assessing inflation trends, including:

Import prices/Shipping prices: High-frequency indicators of export prices from various countries, such as the Yiwu Small Commodity Price Index in China, CCFI shipping prices, and Japan's export price index.

Various survey prices: ISM manufacturing and services price indices, raw material and factory price indices from various Federal Reserve surveys, and small business surveys on price increase intentions.

High-frequency indicators: For example, U.S. gasoline retail prices, CRB food index, Mannheim used car prices, Zillow housing prices, etc., which can provide references for the trends of certain structural components.

Looking back at the July data, we believe the trend of "two extremes" may continue, with major weighted components such as energy, used cars, and housing expected to continue weakening, while other core goods affected by tariffs show stronger upward momentum. Therefore, the offset between the two may not pose significant overall risk; however, the structural importance is rising, and further observation of the scope and breadth of subsequent price increases is needed. A recent example is that, although core inflation in June rose less than expected, the price increase signs of most tariff-related products still triggered expectations for interest rate cuts and a pullback in stock and bond asset prices. Specifically:

On one hand, from high-frequency data, the year-on-year decline in July energy (gasoline retail prices) has widened; moreover, the prices of core components such as used cars and housing continue to decline, with the former mainly influenced by destocking, demand exhaustion, and overseas price reductions, while the latter is suppressed by high interest rates and a slowdown in housing demand, which will significantly constrain the July CPI reading.

On the other hand, for products more related to tariffs and imports, such as clothing, furniture, and leisure electronics, it is difficult to make rough estimates of their price increases due to the lack of corresponding high-frequency indicators However, we can observe some clues from the product prices of large American retailers (calculated by Harvard University). Since July, large American retailers have started a new round of price increases. Moreover, from a structural perspective, the scope of this round of increases is broader: prices of both imported goods and domestically manufactured goods in the U.S., whether affected by tariffs or not, are rising simultaneously (which is different from the differentiated characteristics observed from April to June). This reflects a significant increase in both inflation and its breadth.

From the perspective of micro enterprise behavior, there is a high willingness among companies to raise prices in the future. Currently, the PMI price index for both manufacturing and services continues to hover at high levels. With the implementation of Tariff 2.0 in August, companies' expectations for future price increases and their willingness to raise prices have also significantly risen (the price increase plans of small and medium-sized enterprises and regional Federal Reserve price expectations continue to rise), reflecting that companies' concerns about inflation remain strong, and the scope of future price increases may be broader.

Finally, a question that may have to be considered is: In the current U.S., inflation and inflation data may not be the same thing.

Worried about inflation, but not about inflation data? Due to the "seasonal adjustment incident" of non-farm data, Trump decisively replaced the director of the U.S. Bureau of Labor Statistics. Coincidentally, the collection, organization, and release of U.S. inflation data (which are the most frequently mentioned data by the Federal Reserve this year and thus given different levels of importance by the market) are also the responsibility of this agency. This makes subsequent data comparisons delicate: since Trump has continuously criticized the Biden administration for manipulating and distorting data, it is naturally possible to restore the data to "normal" in the "opposite direction," leading to potential distortions in inflation data.

Assistance from layoffs? Additionally, due to factors such as federal government layoffs, the decline in the availability of survey data since March this year has led to an increasing number of inflation sub-item data being estimated, with the estimated portion in June exceeding one-third (normally around 10%). This may leave more room for manipulation.

Therefore, before the "pain" of inflation is felt, there is a certain probability that the "anesthetic" of data will not dissipate. Indeed, there are many logics, but there is only one truth. When the side effects of inflation appear in forms other than CPI data (or do not appear at all), it will become clear whether this political "dance" is a "perfect waltz on the knife's edge" or if it is running in "the emperor's new clothes." This risk is more likely to gradually emerge in the fourth quarter, and the dancers (traders) should move closer to the exit while dancing before the banquet's wine glasses are taken away.

Authors: Lin Yan, Shao Xiang, Wu Shuo, Source: Chuan Yue Global Macro, Original Title: "U.S. Inflation: Is Now Not the Time to 'Not Worry'?" (Minsheng Macro Shao Xiang, Lin Yan) Risk Warning and Disclaimer

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