The cure for high prices is high prices

Inflation surprise in store?

As you probably noticed, life is getting more expensive. I’m talking about the basics: shelter, food, transportation. Nothing fancy. Just the cost of simple life necessities.

OK, arguably there are cheaper alternatives but most people must bear the additional cost for now.

Shelter: The cost to own a home has risen significantly over the past few months

Food: Production costs pose a risk to the most vulnerable

Transportation: Is it even worth going to work anymore?

For most people, demand for shelter, food and transportation is inelastic. While one can replace filet mignon with ground beef, there are limits to the savings. Wages are growing, they are not keeping up in real terms (chart below). This means the money has to come from somewhere else - namely, discretionary purchases.

I expect people are beginning to think twice about that new car or that new set of furniture. The economy remains strong, but prices should act as a self-limiter on spending.

Given the circumstances, it is reasonable to expect inflation rates (remember, inflation measures changes in prices, not absolute price levels) to weaken over the coming months as 1) spending is reduced and 2) year-over-year comparisons flatten out. We may already be seeing this as recent price changes are less aggressive than year-over-year changes.

Of course, war and natural disasters are the wildcards that appear with unfortunate regularity so none of this is certain. Still, I believe there’s a non-zero probability that softening inflation could start to alleviate concerns about Fed tightening.

Markets would react positively to this outcome. Indeed, 10 year US Treasury yields have already come down dramatically over the past couple days (about 14bps in two days). It’s not clear why this has happened, but the market might be getting a whiff of tamer inflation.

None of this is clear right now, but stay tuned as the story develops…