UBS On-Air: Paul Donovan Daily Audio 'Inflation you can’t believe in'

Paul Donovan · UBS Global Wealth Management

A growing share of US CPI is now estimated rather than measured, so the figures are less precise.

Donovan argues that a larger part of US consumer price inflation is now calculated through guesswork (imputation), so the published numbers are less precise than in the past. He draws the implication that the headline figure should be read with caution and that the level and detail of prices may matter more than the monthly change.

“a larger part of U. S. Consumer price inflation is now calculated through guesswork. So these numbers are not as precise as they used to be in the past.”at 1:34

Paul Donovan · UBS Global Wealth Management

US inflation reflects first-round oil pass-through; second-round effects are generally absent.

Both US headline and core inflation contain an oil price element, and the current pickup mainly reflects the direct passing-through of oil costs into gasoline, transport and similar prices. Donovan sees no broad second-round effects such as profit-led inflation or wage-price pressure, apart from some airfare increases. On balance, the inflation story is first-round oil effects rather than a self-sustaining inflation problem.

“But generally speaking, second round effects are absent.”at 2:47

Paul Donovan · UBS Global Wealth Management

China's government management of retail oil prices keeps gasoline below the full cost of oil.

China's producer price inflation rose to 5%, reflecting the fuel cost increase. Consumers are shielded because the government manages the retail oil price, so retail gasoline prices rose but do not reflect the full cost of oil. The consumer therefore sees less of the oil shock than producers do, which keeps consumer inflation moderate.

“The obvious fuel cost impact was in the producer price numbers, but the consumer has some protection from that by the government's management of the retail oil price. ... Retail gasoline prices did rise, but they're not reflecting the full cost of oil.”at 0:22

Paul Donovan · UBS Global Wealth Management

Chinese consumers are saving more despite low inflation, and falling food prices keep China's CPI moderate.

China's September CPI was 0.9% year over year, a little below expectations. Food is nearly 30% of China's consumer price basket and food prices keep falling, with pork down 10%, which holds headline inflation down. Unlike developed economies, where consumers are cutting saving to pay for higher oil costs, Chinese consumers are maintaining or increasing their saving despite a modest cost of living.

“Food prices keep falling. Pork prices down 10%, for instance. ... China's consumers are maintaining or increasing their saving in spite of a modest cost of living.”at 0:40

Paul Donovan · UBS Global Wealth Management

If US inflation is only first-round oil effects, the Fed needs at most one more hike, not more.

The key policy question is whether the US inflation pickup is only first-round oil pass-through (gasoline, transport costs) or includes second-round effects such as profit-led inflation or wage-price pressure. If it is only first-round, US rates would need to rise once more to show the last hike was not a mistake, but no further tightening would really be required. New York Fed President Williams, an important FOMC voice, has signalled no desire to raise rates next year, which fits this view of the inflation. Any evidence of second-round effects would require further central bank action.

“If it is just first round effects, then US interest rates will need to rise once more to prove that the last rate hike wasn't a mistake, even if it was a mistake. ... But more than that, would not really be required.”at 2:01

Paul Donovan · UBS Global Wealth Management

Airfare increases hint at profit-led inflation, which would feed into core as well as headline inflation.

Airfare increases are the one area where Donovan sees a hint of second-round, profit-led inflation rather than pure oil pass-through. He says this has a faint unpleasant odour and would affect core inflation as well as the headline numbers, although he judges that second-round effects are generally absent overall. The view is tentative and hedged ('perhaps').

“The airfare increases have a faint unpleasant odor of profit led inflation perhaps, and that will affect core inflation as well as the headline numbers.”at 2:41

Paul Donovan · UBS Global Wealth Management

Specific price levels like beef matter more to voters than headline inflation before the midterms.

Donovan argues that the affordability debate will turn on specific inflation details rather than the headline number as the midterms approach. Voters are not believing the official figures anyway, partly because frequency bias and loss aversion make perceived inflation higher than measured inflation. The price level matters as much as the latest change, and beef prices, up considerably over the past eighteen months, are the kind of price consumers and voters remember and focus on. Electricity pricing, linked to AI power use, is also expected to be relevant.

“So for those obsessing about the affordability crisis, it's not the headline number, but key aspects of the inflation details that are going to matter as the midterm elections approach.”at 3:09