Inflation continues to decelerate rapidly

24 April 2023 Following the latest CPI and PPI data, it seems even more clear that inflation mostly peaked around June/July last year and has been easing since, particularly in the last six months. This note follows up on the comments I made back in December, highlighting the influence of shelter costs and the Fed’s […]

Divergent shelter costs are muddying the inflation debate

A key topic within the broader inflation debate is the influence of the biggest single component of the CPI: shelter. At about 33% of the current CPI weight, shelter (housing/rent) costs are clearly important, but measuring them is harder than it might seem.

Inflation in goods is already over

The focus of the inflation headlines, and most of the comments from Fed officials, has been on the year-on-year reported inflation rate of the CPI (or PCE). However, the extremely volatile macro environment has produced far more volatility in reported inflation data than has been seen for most of the last 30 years.

Watching the Fed watching the data

The markets have remained focused on the Fed (and occasionally the Bank of England), and the Fed has kept its focus on the trailing reported inflation data (CPI, PCE, etc.) and on the labor market data (job growth, wages, etc.). The Fed’s view is that inflation cannot sustainably come down to a suitable level (2-3%) unless income growth slows down significantly. That is, income growth must decline to reduce excess demand. This certainly makes sense up to a point, but of course prices are determined by the combination of demand and supply.

All eyes still on the Fed

Short-term movements in stocks, bonds, and currencies continue to be driven primarily by changes in investor perceptions about the Fed’s likely course of action over the next 6-12 months. In response to client questions, the following are some comments and charts reviewing recent history and the current backdrop.

Fed moving rapidly from “tightening” to “tight” monetary policy

The August CPI report released earlier this month was significantly worse than expected, and data since then has not changed the broader view of inflation for the Fed. Along with continued hawkish public commentary from Fed officials, this has driven a further rise in bond yields to new multi-decade highs, and cemented expectations for further aggressive rate hikes by the Fed.

However, despite the “hot” CPI reports, the level of expected inflation in five-year inflation swaps (the most direct way to bet on future inflation) has fallen to its lowest level in a year, and was recently trading around 2.6% (chart below), close to the Fed’s presumed target of about 2.5% on the CPI (dashed line). A similar picture is seen in the 10-year inflation swaps.

Are we fighting the Fed now?

The stock market has rallied sharply since mid-July, while long-term bond yields have been stable to lower. Even the mighty US dollar has paused a bit in its uptrend. But inflation remains high (though likely peaking) and Fed officials continue to say they will continue to raise rates (and reduce the balance sheet) well into next year. The old market adage says “don’t fight the Fed” (i.e., be cautious when the Fed is tightening policy, and more aggressive when they are loosening), but it looks like markets have in fact  been rallying in spite of the Fed lately.

Is the Fed closer to its goals than we think?

Markets remain volatile, but the narrative driving the volatility has been shifting recently, a topic we have written about and discussed with clients recently. For much of the year, the concern was that the economy was “too strong” and inflation was out of control, and thus the Fed would need to raise rates and reduce their balance sheet quite aggressively to combat inflation.  The Fed has taken several steps in that direction, but now conditions have changed such that investors are more worried about growth slowing too quickly and turning into a recession rather than excessive inflation.

Commodity prices diverging: energy vs the rest

Last month we commented that while the CPI readings remain very high, there are signs of moderation in commodity prices. With commodity prices remaining center stage as a macro driver, we continue to closely watch the various commodity indices, including the S&P GSCI index and its subcomponents.

There now seems to be a greater divergence between energy prices and other commodities.

The chart below shows the S&P GSCI Commodity Index (top section) along with its component indices over the last three years.

CPI remains high, but commodity prices stabilizing

The latest CPI report yesterday showed prices in April still rising at a worrisome rate, led by recovery in service-related spending like airline fares. The monthly increases in the headline CPI and the core (excluding food and energy) rate were both above consensus expectations.

Notably, the core rate (+0.6%) rose substantially more than the headline rate (+0.3%), as the impact of food and energy was negative in April. However, the year-on-year increase in the headline CPI, which eased slightly to 8.3%, is still substantially higher than the core rate of 6.2%.