Someday, perhaps, we’ll get to stop talking about inflation. As long as prices remain the most important variable in the economic outlook, though, we’ll keep providing updates for our readers.
Last week, we received a fresh batch of inflation data with the August CPI and PPI reports. The Consumer Price Index revealed positive news for economic observers. Core inflation fell for the fifth straight month, and on a 3-month annualized basis, dropped to the lowest level since March 2021.
However, that good news came with a caveat. ‘Core’ measures of inflation strip out the price of food and energy – and energy prices are reaccelerating.
Inflation data continued to show positive developments in last week’s report. Even though CPI rose modestly from the prior month’s 3.0% year-over-year print, the 3.2% reading was still better than most analysts had forecast. The biggest improvement came from so-called “core” inflation, which strips out volatile food and energy components of the CPI and is a better indication of the underlying inflation trend according to economists at the Fed. Core CPI dropped to 4.7% year-over-year, still more than double the target of central bank policy makers. Over the last 3 months, though, the reading has dropped to an annualized level of just 3%. That’s the lowest in almost two years.
The continued moderation is little surprise to us. We’ve been pointing out that inflation has been rather subdued for more of the last year. In September 2022, CPI ex-shelter dropped to 0% on a 3-month annualized basis, and it’s remained near the Fed’s target ever since. The year-over-year number is a paltry 1.2%.
The Fed’s Fight Against Inflation is Coming to a Close
After the most aggressive interest rate hiking cycle in 40 years, the Federal Reserve is close to achieving its goal.
Yes, annual measures of inflation are still above the Fed’s 2% target, and the FOMC will most likely raise rates again at next week’s policy meeting. We usually refrain from making economic forecasts, but we believe next week’s hike will likely be the final interest rate move of 2023. Consider the following:
Inflation is moderating faster than even the optimistic forecasters had anticipated. During June, CPI slowed to a 2.969% annual rate, less than half of the rate at year-end, and just one-third the rate from a year ago, when prices pressures were at their peak. That decline bodes well for next week’s report on the Fed’s preferred measure of inflation, the PCE Deflator.
Headline PCE has declined steadily over the past year, supported by falling energy prices. However, the Core measure, which excludes energy, has remained stubbornly elevated. So how can we be so optimistic about the outlook for prices when the biggest drag on inflation has been energy, and energy costs are unlikely to continue falling at such a rapid pace? For one, those falling energy prices will transmit to the rest of the economy via lower input and transportation costs. Additionally, the largest contributor to higher prices is becoming less and less of a problem.
Yes, inflation is still much too high. At 5.3% on a year-over-year basis, Core CPI is still more than double the Federal Reserve’s 2% annual target. Even when we look at just the last 3 months and annualize that number, prices have proven to be quite sticky – they’re running at a 5% annual rate.
But measuring inflation is tricky, and these calculations have well-documented flaws when it comes to measuring housing inflation. Consider that back in July 2020, home prices began accelerating. By the end of the next year, home prices were rising at a pace of more than 20% per year, the fastest we’d seen in decades. Yet for the first 6 months of that historic rise, the CPI measure of shelter inflation was actually falling.
Part of the problem is that rent prices didn’t follow the same arc as homes prices, and rents are an important component in the CPI calculation. But the lag effect is still quite clear: home prices have a significant, but delayed impact on CPI for shelter. We saw the same phenomenon back in 2005, when home prices began to fall. It took almost 18 months for the inflection lower in home prices to show up in the measure of housing inflation.
Now, home prices are falling again. The peak in annual home price gains was more than a year ago, and the Case-Shiller National Home Price Index even went negative in recent months.
We’re finally starting to see those softer home prices show up in the CPI data. CPI for shelter has peaked, and on a 3-month annualized basis it’s already dropped more than 3.0% from its peak.
So why is all that important?
Because CPI ex-housing has been running at or below the Fed’s 2% target since last fall. The 3-month annualized change for this measure dropped to zero last September, and hasn’t really changed since. We’re now a whisper from hitting 2% on a y/y basis, too. Housing inflation is coming down, and inflation less shelter is already under control.
Energy prices coming down have been a big tailwind for lower headline inflation, to be sure. But even excluding that, as we do in the core measure of inflation we shared at the outset of this update, inflation is trending lower at a rapid pace. Shelter is a whopping 40% of core CPI. Currently running at 8%, that means shelter alone accounts for 3.2% of the 5.3% annual core rate. Everything else sums to just a 2.1% annual rate.
Slowly but surely, prices are starting to normalize.
Consumer prices in the month of April rose at an annual rate of less than 5% for the first time in 2 years. Even more encouraging, the annualized 3-month change has been below 5% since September. That’s still above the Fed’s 2% annual target, but it’s not far above the levels we experienced in 2017 and 2018. The deceleration has been driven by energy prices, which have fallen 5.1% over the last 12 months.
Unfortunately, core inflation remains persistently elevated, and that measure tends to be a better indicator of future prices. Sticky services, a resurgence in the price of some durable goods, and housing costs are to blame – Core CPI rose at a 5.5% annual rate in April.
The good news is, housing costs are finally showing signs of stabilization. After more than two years of acceleration, the year-over-year change in the price of shelter ticked down in April. To be sure, it’s tough to get excited about 8% inflation in the single largest component of the CPI. But leading indicators of this index, including rent prices and national home prices, point towards continued normalization in the months ahead.
Business surveys indicate that price pressures are easing, too. The latest NFIB report showed that planned price increases from small businesses were back to pre-pandemic levels. Perhaps that’s because input costs are falling? Polls conducted by regional Federal Reserve banks show at prices paid for raw materials are returning to historical averages. In Philadelphia, the latest number was lower than any we’ve seen since 2016, pandemic extremes aside.
That’s a good sign for future inflation readings.
Focusing on the Fed
The Federal Reserve raised rates for a tenth consecutive meeting earlier this month. The hike came as no surprise, as most officials had voiced support for a more restrictive policy stance even in the aftermath of recent bank failures . Neither was it surprising, though, when Chair Jerome Powell laid the groundwork for a pause by removing language from the prior meeting’s press release that indicated additional policy firming would be necessary, and replacing it with more flexible language that highlights the Fed’s data dependence going forward. The latest hike brought rates in-line with the median year-end expectation of FOMC members, as indicated in the most recent Summary of Economic Projections. Incidentally, that’s also where the policy rate stood immediately before the Great Financial Crisis.
The Chair believes policy is near a level that is sufficiently restrictive to bring inflation down to the Fed’s 2% target. While recent meeting minutes showed that Fed staffers now project a mild recession later this year, Powell himself still believes a low-growth outcome is the most plausible. For that reason, he doesn’t believe the Fed will be forced to cut rates anytime soon. However, he voiced an openness revising his expectations should the data change.
Ever the pragmatic pivoter, he indicated that he’ll be focusing a bit less on incoming inflation and employment data, and more on how cumulative tightening actions, ongoing QT, and recent bank failures will affect credit creation and stymie demand. To his point, the May release of the New York Fed’s Senior Loan Officer survey showed that credit standards for consumer loans are tightening at a pace we’ve rarely seen in the past 25 years.
A Look at What’s Ahead
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Nearly half of S&P 500 constituents will report first quarter earnings over the next two weeks. If consensus expectations are correct, they’ll show that company profits are declining for a second straight quarter. Back-to-back EPS declines would signal the first ‘earnings recession’ since 2020, when COVID lockdowns brought the global economy to a grinding halt.
Since that time, corporate profits have risen at a pace that far exceeds the average annual EPS growth rate of 7%. Estimates for 12-month forward earnings are more than 60% higher than their 2020 lows.
Stimulus-fueled demand and record profit margins were largely to thank for that rise – but now those tailwinds have faded.
Revenues in the first quarter are expected to rise only 2% according to FactSet, substantially less than the annual rate of inflation. Profit margins are contracting, too, from last year’s elevated rate of 12.2%, to more modest 11.2%. Taken together, that points to an EPS decline of 6.5%. You rarely see that kind of drop outside of economic recessions.
Fortunately, actual earnings usually exceed expectations. In most years, consensus estimates trough in the weeks ahead of the reporting season, then hook higher as companies beat lowered expectations.
US large cap stocks erased their hot start to the year, declining more than 5% over the past month. The S&P 500 Index has dropped back below a falling 200-day average. The Dow Jones Industrial Average is down just 2.4% over the last year, but it’s been the laggard so far in 2023. The NASDAQ Composite, meanwhile, has been the best performing major index over the last month and quarter.
Bond prices continue have risen dramatically over the past week, after turbulence in the banking sector spooked investors. Still, the 10-Year Treasury note remains below a falling 200-day moving average – clear evidence that a downtrend still exists. While yields are down from their October peak, the threat of continued policy tightening by the Federal Reserve remains a risk for fixed income investors.
US large cap stocks have jumped more than 7% to start the year and continue to erase last year’s decline. The S&P 500 Index is further above its 200-day average than at any point in the last 12 months, as stocks attempt to enter a new bull market. The Dow Jones Industrial Average is down just 1.4% over the last year, while the NASDAQ Composite has been the best performing major index over the last month and quarter.
Bond prices continue to fall as interest rates rise. The 10-Year Treasury note is stuck below a falling 200-day moving average – clear evidence that a downtrend still exists. While yields are down from their October peak, continued policy tightening by the Federal Reserve poses a threat to fixed income investors over the coming months.
US stocks have rallied over the last several months, a welcome reprieve from the persistent downward pressure that punished investors for most of 2022. The S&P 500 has returned to its 200-day moving average for just the second time since last spring, threatening to put an end to its technical downtrend. The Dow Jones Industrial Average continues to be the outperformer among the major US indices, rising more than 15% over the last quarter. It’s now down only 5% over the last year. The NASDAQ Composite, meanwhile, would need to rally more than 40% to return to all-time highs.
Bond prices are still in a clear technical downtrend, as the 10-Year Treasury note is stuck below a falling 200-day moving average. Still, the benchmark yield has fallen to 3.5%, well below the 15-year highs seen in October.
Equity prices have been steady over the last month and continue to be led by the Dow Jones Industrial Average and its tilt towards value stocks. The Dow is down only 4% over the past year, while the growth-oriented Nasdaq Composite is down a whopping 27%. The S&P 500 remains in a technical downtrend, with a current price below a falling long-term moving average. However, even when the index was at its lows for the year, prices never fell beneath their pre-COVID highs.
The 10-year Treasury yield has fallen below 3.5% after touching a 15-year high of 4.3% in October. The decline follows a shift in Fed policy expectations over the coming months. The year has still been a disappointment for bond investors, with the Aggregate US Bond index tracking for its worst annual performance on record.