I’m undertaking a 1000-day reinvention project, blogging here daily to track my progress. In Thursday Thinker, I share a smart idea or theory.
The market mostly shrugged off this week’s CPI report showing an increase to 4.2% from 3.8% in April. While broad market indexes have been weak, market-based inflation predictions continue to fall, suggesting sentiment that the price shock from the Iran war is temporary.
In this morning’s Bloomberg Points of Return newsletter, John Authers and Richard Abbey write that the market may be a bit too complacent. Breaking down the CPI into components shows that the rise in the CPI isn’t just due to increases in energy costs.
The rise in the energy component is obviously important, but services remain obdurately high, while food inflation — politically salient these days — hasn’t gone away. These numbers rule out a rate cut.
More to the point, alternative measures of core inflation signal that pressure is rising. The Fed’s favored “supercore” of services excluding housing is rising sharply, while the Atlanta Fed’s gauge of sticky price inflation, covering products whose prices take time to change and are difficult to cut, has risen above 3%. Both the trimmed mean, excluding outliers in either direction such as oil and averaging the rest, and the median also rose and are higher than CPI excluding food and fuel.
Gianluco Benigno, professor of economics at the HEC-University of Lausanne, suggests that the real danger here lies in supply chain disruption:
the bigger risk from the current Middle East shock is not a one-off price spike. It is persistent inflation, the kind that takes years to unwind, not months. And the reason for that distinction is not about the level of oil prices. It is about whether the disruption is large enough, broad enough, and durable enough to activate a very specific and underappreciated mechanism: the nonlinear propagation of supply chain stress through the entire production system.
Is the market in denial?
Right now, the market seems to think that (1) any energy supply shock will be short-lived and will resolve quickly once the war concludes and (2) the Fed funds rate will follow the oil price. You can conclude this by looking at implied Fed funds rates, which rise and fall with oil price futures changes and ceasefire headlines.
Benigno writes:
Oil futures are necessary but not sufficient. They tell us something about the direct energy-price impulse. They tell us much less about the cumulative production-network cost of disrupted logistics, rerouted cargoes, LNG shortages, and delayed inputs. And they embed the assumption that once the geopolitical dust clears, the inflation consequence clears with it.
Benigno’s research suggests that with “normal-sized” supply chain shocks, PPI spikes then fades, leading to a rise in CPI with a modest rise in core, and then a medium-run normalization.
But in a large shock (defined as the top historical decile of GSCPI, the global supply chain pressure index), core does not normalize over the medium-term policy horizon. Core inflation purports to measure the underlying long-run trend of aggregate price levels in the economy, removing items with short-term significant price fluctuations such as food and energy. Benigno points to a nonlinear response: with a large shock you get a disproportionate rise in core CPI, which is a persistent form of inflation.
Why is there this nonlinearity?
Supply chains have buffers that allow them to manage small- to medium-size shocks: they store inventory that they can use up before buying more inputs, they have some pricing flexibility, they can negotiate with suppliers. This helps absorb the shock and can prevent it from propagating through the chain.
But, Benigno suggests, these buffers can’t accommodate severe disruptions:
The cascade compounds: each stage passes through a higher fraction of its cost increase, and the cumulative pass-through amplifies. A Hormuz closure does not just raise oil prices. It has stranded LNG, disrupted petrochemicals and fertilizers, and raised maritime logistics costs at every stage simultaneously.
And there is a second, conditional mechanism that may occur:
When disruptions are severe and sustained enough, they stop being perceived as transitory. Workers facing real income losses demand wage compensation. Firms, observing that competitors are also raising prices and facing persistently higher input costs, incorporate cost expectations into new price-setting rather than absorbing them. Inflation expectations drift upward.
This channel depends on the state of the labor market and how salient inflation already is to firms and workers at the time of the shock. A tight labor market in which workers have already experienced one inflationary episode provides more fertile ground than a slack one. That is the relevant context today: labor markets in the US and Europe have not fully normalized, and inflation expectations carry residual sensitivity from the 2021–2023 episode.
The wage-price spiral is typically the main inflation propagation mechanism that economists point to. But Benigno seems to argue that the supply chain disruption is automatic and primary. On its own, it’s powerful enough to generate inflation persistence that standard linear models miss.
What do the numbers say right now?
Benigno published his article in late April, when GSCPI numbers from March were available. At the time, the most recent GSCPI reading was 0.68 standard deviations, “elevated but not alarming by pandemic standards.”
He suggests that a reading as high as +1.5 or + 2.0 would “approach the historical threshold range associated with nonlinear dynamics.” April came in at 1.82 and May at 1.77, so it has risen to the level where a disproportionate inflation response may arise.
But this week’s CPI numbers were less worrying than they might have been:
Overall, the May CPI release suggested that inflation pressures remained elevated, but the underlying inflation impulse was, if anything, softer than the headline numbers alone imply. Headline CPI increased to 4.2% YoY, supported by higher gasoline prices and broader transportation-related costs as the Middle East energy shock continued to affect global oil markets. Core CPI edged up to 2.9% YoY from 2.8% in April on base effects, even as the monthly core pace eased to 0.2% (s.a.), with the remaining firmness concentrated in selected tariff-sensitive goods (notably apparel) and airline fares. Shelter and broader core services inflation remained well below their post-pandemic peaks and slowed further on the month, suggesting that the recent inflation impulse stayed concentrated in energy- and import-sensitive sectors rather than signaling a generalized reacceleration across the wider consumer basket.