U.S. Inflation: Where are we headed?

Erik Johnson:

One of the reasons why we're seeing rent prices decline in parts of the US South and Sunbelt is because those are markets where it's a lot easier to build housing supply. And so the reason rent prices are falling right now is because a lot of supply is coming on the market at the same time that that demand shock that we saw in the pandemic has calmed down and there's not the same desire to head to the periphery that there was three years ago or so.

Michael Torrance:

Welcome to Sustainability Leaders. I'm Michael Torrance, chief Sustainability Officer at BMO. On this show, we will talk with leading sustainability practitioners from the corporate, investor, academic and NGO communities to explore how this rapidly evolving field of sustainability is impacting global investment, business practices and our world.

Speaker 3:

The views expressed here are those of the participants and not those of Bank of Montreal, its affiliates or subsidiaries.

Alma Cortés Selva:

Welcome back to another episode of Sustainability Leaders. I am Alma Cortés Selva, senior Advisor at the BMO Climate Institute. In today's episode, we will be talking about inflation, housing costs in the US, an extreme weather events. I am joined today by Erik Johnson, vice President Global Markets Economics at BMO. Thank you so much for coming to the show, Erik. And if you don't mind, introducing yourself to the audience.

Erik Johnson:

Yeah, absolutely. Thanks so much for having me here, Alma. I'm an economist with BMO Capital Markets. I'm in our economic research team. I cover a range of different topics, but one of those in particular is the interface between the macroeconomy and climate change

Alma Cortés Selva:

I think our audience will be really interested in talking about inflation, especially since it has eased from recent highs. But what does that mean in terms of what consumers are seeing on the day-to-day basis?

Erik Johnson:

Yeah, so I think inflation is one of these things, one that certainly really stays on the minds of consumers. when they're going to places like the grocery store, say if they're going to fill up their gas tank, all these sort of points of daily contact, they're seeing rapidly changing prices

And I think what's important to recognize here is that what economists, or what statistical around the world try to do when they're measuring something like inflation is they're trying to kind of come up with a proxy for what's happening with some broad measure of the cost of living. So the idea is like what's happening for the average household in a society when they're going out and trying to buy all the various goods and services that make up sort of their hypothetical basket of those things that they consume.

And the second piece you want to think about there is inflation is really a measure of acceleration or a rate of change and not a level effect. And so I think there's a few things that matter when you're thinking about what that means on an individual basis in today's economy, particularly in the US.

so obviously we've come down tremendously from those near double-digit highs that we saw a little bit more than a year and a half ago now. But if we're thinking about some individual components here, so if we're thinking about how much it costs to say buy food at grocery stores today versus the end of 2019, those prices are up 26% or so relative to where they were almost four years ago or a little less than four years ago now. And so I think what that is speaking to is that although the rate of change of prices has slowed down, the level effect there is really the challenge that a lot of consumers today are still dealing with.

So yes, the rate of change of prices is certainly coming back in line with what we were used to seeing a little bit more. It's still certainly above target, but it's that level effect that doesn't really go away and is what's making this a challenging environment for households to manage in.

everyone's basket is going to look a little bit different and so when they're going out buying things, paying for services, even if say that CPI number is hovering just over 3% in respect to what their budget or what their basket looks like, their basket might not be growing in line with what that aggregate measure is showing.

And so sometimes that's a little bit of the disconnect that people often feel. A good example is if you're going out to buy a home for the first time, you're probably going to think 3% doesn't seem like a fair price increase when you're going to buy a house that's seemingly rising much more than that from what you might've been used to seeing just by seeing that aggregate statistic there.

Alma Cortés Selva:

You mentioned several of them, you mentioned groceries, you mentioned gas, you mentioned housing. Housing is one of the big ones because it represents a third of the consumer basket. It has gone up almost 6% from the prior year according to the Department of Labor, what do you think are some of the reasons that we see shelter, housing that inflation persisting or it doesn't go down and it remains persistent and high?

Erik Johnson:

Yeah. So shelter is certainly in many ways one of the most challenging prices out there to measure when we're thinking about these big price indexes like the Consumer Price Index or the Personal Consumption Expenditures Index. the main difference for why the PCE Index is actually about a percentage point or slightly less than a percentage point lower than the Consumer Price Index is it places a lower weight on shelter. In fact, it places even less than half the weight on shelter than the CPI and it's just a little bit different about how they're constructed.

So the PCE is trying to represent all the out-of-pocket and third-party expenditures that go into an economy. So a great example of that is healthcare. So if you have health insurance, if you're going to receive a medical service, part of that might be your copay or some other kind of add-on payment you directly have to make, but if your employer provides your health plan, your employer is also paying for that service as well. In the CPI, we don't consider that, but in the PCE we do. And so that's one of the reasons in the PCE, some of those other components take up more of that basket than shelter does in the CPI. So there's just one very simple example of why shelter prices can have upsize effects on some of these measures than CPI in particular.

But another challenge is housing is a little bit different than say me going to a grocery store and buying an apple, right?  it's very much a consumable item.

The challenge with a house is it's a little bit different than that. The average home in America is often held for up to 10 years and there's two various components of that. A house primarily is something that people consume as their means of shelter. But there's this other aspect of it which is this financial asset or investment tool. And so when we're trying to think about measuring the cost of living in an economy, what the challenge there is we really want to capture that consumable piece of the house without trying to also incorporate this idea that a house is also being an investment vehicle at the same time

And the way that the US has kind of decided to incorporate those costs is basically by thinking about a house as this rental object. So for people who directly rent, one of the measures that's in the shelter component of CPI is essentially the average movement of rental prices in the economy. And it's important to recognize there that there's two very different components of that.

So if you were to think about what's happening to the rental prices for a new tenant, , according to the underlying data that the Labor Department uses to build their own shelter CPI measures is that New Tenant Price Index is actually lower at the end of last year than it was a year ago. And so I think what that's suggesting is that rental prices actually are turning over in the United States. The challenge is those are new tenants and what you want to capture in a broader index is what's happening with everyone, both existing and new tenants.

And so rather than reflecting maybe what's happening right now, what they're actually reflecting is what might be happening a year ago or sometimes even 18 months ago. And so the reality here is these objects that we put into these price indexes to measure shelter prices are just very slow moving. Because again, if you just look at the average total tenant movement in rental prices, that's still quite elevated as you were pointing out, it's still not quite 6%, but it certainly hasn't normalized anything close to the Fed's target of 2%.

And so that's one of those components. But I think when you want to think of the overall forces of why house prices and shelter prices generally got so upsized in the last few years is we had at the one hand this big demand shock for different kinds of space than we were used to seeing demand for. So especially at the height of the pandemic, there was this big desire to get out a little bit more into the periphery and even the exurbs of city and get a little bit more space. And the reality is in some markets there's just not a lot of those properties out there. And so the challenge is that supply side of the economy isn't really able to respond readily and quickly in a high interest rate environment to meet that imbalance between demand and supply. There's certainly very different versions of that across the country and one of the reasons why we're seeing rent prices decline in parts of the US South and Sunbelt is because those are markets where it's a lot easier to build housing supply, and so the reason rent prices are falling right now is because a lot of supply is coming on the market at the same time that that demand shock that we saw in the pandemic has calmed down and there's not the same desire to head to the periphery that there was three years ago or so.

Alma Cortés Selva:

Shifting gears a little bit, we have states like Florida, Louisiana and California that have becomes insurance deserts all due to increasingly devastating extreme weather events. So that makes insurance either extremely expensive or just simply impossible to procure. What effect do you think it's having on homeowners and is it affecting home prices or the ability to buy a home?

Erik Johnson:

Yeah, so I think to tie this back to the conversation we were having earlier, I think one of these things that is also showing up in these price indexes and these measures of the cost of living is what it costs to get insurance today. And so homeownership is a great example of that. Another thing that's really been affected by the last three years is auto insurance as well. And so I think what's particularly challenging about home insurance in these markets that are a little bit more affected by some of these physical risks that are sort of starting to rise from climate change is we're adding this additional layer of potential costs.

And so I think there's a few different challenges that's posing. So one, higher prices are meaning that there's a number of homeowners out there who are canceling their insurance policies because they can't pay for them, and that's certainly exposing them to a huge risk. So something like a hurricane stands out if we're thinking about places in Florida and other parts of the East Coast,

I think the challenge is, depending on the market, there's not a lot of definitive research showing great connection between some of these physical risks today and home prices, but we are starting to see some, so there's some research now pointing to exposure to sea level rise being one of those factors that is kind of negatively weighing on home prices if we were going to compare a similar home in an area that's not exposed to sea level rise that has all the kind of same features. So again, I think those things are starting to manifest themselves.

And I think as we continue to go forward, we'll start to see things like wildfire risk, drought risk, all of these other risks that are associated with some of those physical changes that climate change is bringing to start being capitalized into home prices.

Even if you don't live in one of these areas that's a little bit more exposed to something like sea level rise, so you live more in the middle part of the country, why you should care about that kind of effect is there's two different facets.

the way that insurance products often work is everyone is paying into a pool, and if that pool is continuing to be dominated by these really big events that are happening on the coast because of physical risks of climate change, in essence, you are paying for those things. So even though if you live in say, Minnesota that might have lower exposure to some of these effects, you might end up having to pay more for your home insurance to make the pool work for an insurance company across the country

And the second piece of it more from a public financing point of view is what this is ultimately doing is potentially putting more of the backstop on the American taxpayer. So if you have a big disaster and insurance companies have largely walked away from a market, a lot more of that disaster recovery, the replacement of property, a lot of those costs are going to end up falling on FEMA and other agencies at the federal level and the state level. And yes, maybe that feels a little bit less like it's coming out of your pocket, but indirectly it is in terms of higher future tax rates. So I think that's another reason why everyone in the country should really care about what's happening with these insurance companies stepping away from these markets and just with home insurance prices skyrocketing as they are.

Alma Cortés Selva:

Given all that you mentioned that we see more physical risks coming in from the coast or let's say the California wildfires, are we seeing in the data migration patterns or people moving away from affected areas to safer states, or not yet?

Erik Johnson:

So I'd say there's two challenge to this. So one, it just so happened that the pandemic shock over the last four years when we're thinking about what it meant for migration patterns in the US is you naturally had an outflow from really expensive markets to markets that have a little bit better housing affordability. So people were leaving places like the Bay Area and going to different parts of Arizona And so that does look a little bit like that even if it's not directly reflective of the underlying say physical risk.

But I think we are seeing some of that a little bit more today in communities that were devastated, let's say, by big wildfires. But certainly if you look at some of the historical studies, there isn't as much evidence to suggest that there's a huge migration response in the US so far to some of these bigger physical risks. But I think you're going to continue to see those go up as we head into the next several years here.

Because again, I think the challenge with climate change here is not that you just get volatility, is that you're going to continue to see these effects that we've had in the last several years, not just continue, but in many ways intensify.

Alma Cortés Selva:

Extreme weather events have also been cited by multiple research articles as one of the factors that exacerbate inflation. How are extreme water events affecting or impacting the supply chain and the production in the US? And then what has happened in the last few years? Do you mind going over it a little bit because we saw the impact on housing, but it seems that there's more, that extreme weather events impact production, impact the supply chain?

Erik Johnson:

Absolutely. So I think we already touched on this a little bit. One of the very direct ways that physical risk events are changing the cost of living for people is what's happening with things like home insurance markets or even auto insurance markets. It's making these things that much more expensive and just that much more difficult to offer as a risk sharing product. And so I think that's going to be something that is here to stay and in many ways could get worse as we go forward

But I think there's a longstanding research line that focuses on the relationship between extreme heat days and labor productivity. And so I think a challenge that we're going to have to continue to deal with is the more of these summers that we have to deal with where we get not just one-off heat waves but sustained heat waves, those are things that very much weigh on labor productivity, particularly for jobs that have to work outside and aren't in fully air-conditioned spaces the whole time. And so that's one of the very direct ways which we can see physical risk manifesting itself as higher inflation in the future. Just by lowering productivity, it means we're going to be spending more money to produce the same things.

And if we want to tie it back to housing supply, one of the very important jobs that we're going to need to continue to ramp up here in the United States over the next several years is housing construction. And housing construction's largely a job that happens outside, especially in the initial phases of any big project. And so the more extreme heat days we have in the summer, that's certainly going to limit how much we can do on the housing supply side. And so again, that's something that very much feeds into that supply chain and can potentially raise the future costs of any of those kinds of projects in the future.

Alma Cortés Selva:

We have the Inflation Reduction Act in the US, has it been playing a role in reducing inflation? I know it's been very important as a climate legislation. Was it designed to reduce inflation or for some other impact?

Erik Johnson:

I mean, I feel like the Inflation Reduction Act is in some ways a poorly named bill. Certainly if you're interested in federal climate legislation, it is by far the most impressive piece of legislation that has ever made it into law in the United States, and certainly it is already having dramatic impacts on the amount of clean technology investment in the United States and will continue to do that. But if we want to think of the near term effects of the bill on inflation, generally one of the potentially big drivers of inflation in any large economy is what's happening between the overall balance in an economy between aggregate demand, so all of the things that people want to buy out there and aggregate supply, so basically how much we can produce as an economy.

And one of the certainly features of the US over the last several years, and we can go back even further than that, is that generally the federal government in particular has been a little bit more on the largesse side. We're running pretty significant deficits relative to GDP and in an environment where demand is diminished, that's actually a great thing. So if we're in the midst of a recession, typically a very good Keynesian response to that recession is for the government to sort of be this spender of last resort and go out there and stimulate the economy and pump demand enough so we don't end up with as bad of a down cyclical event as we would otherwise. The challenge is right now the US economy is actually operating, what you'd argue is above capacity. GDP growth is, in the US, is quite above trend. We ended last year above 2% growth. We just revised the last quarter up of 2023 to 3.4% growth annualized in the US. So again, that's certainly an economy that's humming along, that consumers are out there spending certainly a lot on consumable things.

And so if on top of that, if the government's also spending a lot of money, that's generally going to put more pressure on inflation than less pressure on inflation. And so because of how generous some of these provisions are for clean technology, a lot of the initial estimates of the cost of the IRA were in that 350 to 400 billion range over the next, I guess what, seven years or so by 2031. But now just the uptake has been so tremendous, and I think if you are interested in the clean technology future of the United States, this is a fantastic news piece, but certainly if you're interested in the near term budget balance, maybe less of a high point for you. But cost estimates have roughly doubled for the IRA, so they're now running more in the 780 to $800 billion range. So on the near term, that's probably, if we're going to classify it as being inflationary or deflationary, we'd probably classify it as being inflationary.

But I think if you're wondering why you would call something like the Inflation Reduction Act, exactly that name is, if we're projecting out where the US economy is going to be in say 2030 and beyond. One of the key components of getting any economy right now to something that's a little bit more aligned with a net-zero pathway is an electrification process. So a lot of the primary energy system in the United States is today reliant on fossil fuels. And so if we want to shift it to one that's using a lot more electrification as opposed to fossil fuel base for primary energy, you need to build that capacity. And so that's one of the things the IRA is certainly starting to deliver right now and will become even more evident five to 10 years from now. And so I think what you want to think about is what is the IRA potentially going to do to electricity prices and just energy costs generally say by 2030.

The nice thing about some of these renewable technologies or some of the other kind of energy systems out there is they act a little bit more like what we might call a technology cost curve. So generally what you see, let's say, computers are a perfect example of this, is initially these things are very expensive, but over time we just get much better at making them and much more efficient at delivering the same amount of computational power in the sense of a computer, but in electricity system, the amount of energy delivered for every solar panel we're using or every turbine we're putting up. And so that's the advantage of something like the IRA. We're shifting the electricity system to something that's potentially going to be less tied to a commodity cycle, and so it generally can deliver not just predictable energy prices, but lower energy prices if we build the capacity there for it.

And so I think when we're projecting out five to 10 years from now, that I think is the potential deflationary effect of something like the IRA. It's about spending a little bit more now to build the capacity to build a more predictable and technology oriented kind of energy system that hopefully delivers some of these technological progress on the cost side that let us produce more electricity than we're using today, but at a lower overall cost.

So I think that is the upside and maybe why kind of that name got thrown out, but certainly if you're thinking of your immediate, what is it doing for me today for my electricity prices or for the cost of some things, not that much unless you want to go out and buy an electric vehicle, in which case it is actually doing certainly a lot in the sense that if you're buying an electric vehicle today, you can get up to $7,500 off the purchase price. And certainly there are some restrictions on country of origin and some of the technologies that go into that electric vehicle, but if you want to lease that vehicle, there's a lot fewer restrictions that come with that. So that would be maybe the one thing I would point to. It is certainly lowering the price right now if you want to go out and buy an electric vehicle today.

Alma Cortés Selva:

You gave us an overview of the interest rates and what's expected to happen. Now again, thinking big picture, what do you think we can expect for inflation for 2024 overall? Because you guide us a little bit, five years, 10 years, what the Inflation Reduction Act may do, but what can we expect for 2024?

Erik Johnson:

Yeah, so I mean I think, listen, there's good news for consumers and certainly businesses going ahead for 2024. So I think yes, the first two months of this year, we've seen a little bit more volatile and upside surprises on inflation than we are expecting. But I think the broad takeaway here is that we're continuing on this, I guess we'll call it slow, but sustained journey towards inflation coming back closer to something we're used to seeing. So something a little bit closer to the Fed's 2% target, and I think one or two months at the start of the year aren't really going to jeopardize that progress, but I think it is going to be a little bit of a slow grind. So if we think of some prices are certainly slowing down, so food and home prices are certainly falling already below target. Food away from home, so that's when we go out and eat at restaurants are still a little bit above target, but those have started to fall meaningfully as well.

So I think what we're likely to see is some of those prices really start to turn over by the end of this year. And so certainly in our view, we will be, at least CPI will come under 3% by the end of this year, and we'll be back a little bit closer to what we'd expect changes in inflation to be as we head into 2025.

Now, core inflation is going to be a little bit slower moving, but again, I think core inflation is one of those things that is going to start to turn over as we get to the latter half of this year. And again, it comes back to shelter. So part of the benefit or the downside of shelter being this really backward looking object in these price indexes is by the time you get to the second half of this year, that's a period of time that starts to have much better base effects if we go back a year or we go back 16 months, and so that's something that's going to start to really benefit those headline series.

Alma Cortés Selva:

That sounds like good news for us consumers. Is there anything else that you'd like to add?

Erik Johnson:

Yeah, I mean, I think that certainly the challenge for this year is going to be this delicate balance between trying to thread the needle of slowing down the US economy a little bit because still running hot. At the same time, we don't want to slow it down too much to the point that we end up with something that looks much less like a soft landing and more like a hard landing. And so I think that's the delicate balance that certainly central bankers are having to walk both globally and in the U.S.

And I think if you are staring out there into the world and trying to figure out what the Fed is looking at, I would say certainly looking at where the next CPI and PCE kind of price index reports come in, that's really going to be the key thing they're going to look at as we go forward, just in the sense that a lot of those real economic measures continue to outperform most people's expectations. And so really what we want to see is just more and continued sustained progress on some of those consecutive CPI reports we'll see over the next few months. And if you start to see those meet or even exceed people's expectations for where could turn over, then I think that's a world where you should be a little bit more confident that the Fed's going to go out there and start to cut rates in the second half of this year.

Alma Cortés Selva:

It sounds like good news to me. Thank you so much for joining us for this episode where we reviewed the expected trends of inflation and housing for this year in the US. Thank you so much, Erik. Really appreciate it.

Erik Johnson:

Thanks so much for having me, Alma. Pleasure to be with you.

Michael Torrance:

Thanks for listening to Sustainability Leaders. This podcast is presented by BMO. You can find our show on Apple Podcasts, Spotify or your favorite podcast player. Press the follow button if you want to get notified when new episodes are published. We value your input, so please leave a rating, review and any feedback that you might have or visit us at bmo.com/sustainabilityleaders. Our show and resources are produced with support from BMO's Marketing Team and Puddle Creative. Until next time, thanks for listening and have a great week.

Speaker 5:

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