December headline and core CPI came in largely in-line with expectations (-0.1% month-over-month, seasonally adjusted for headline CPI, and +0.3% month-over-month, seasonally adjusted for “core”), but under the hood, there’s plenty of reasons to be encouraged.
First, since Chair Powell’s presentation at the Brookings Institution in November (https://www.brookings.edu/events/federal-reserve-chair-jerome-powell-the-economic-outlook-and-the-labor-market/), the Fed has decided to look at inflation in three buckets. The first bucket is goods inflation, the second is shelter inflation, and the third is services ex. Shelter (shelter is otherwise included in the bigger bucket of services). Powell and the Fed have acknowledged that goods inflation has finally started to revert back to pre-COVID levels (which was essentially zero, and December marks the third month where goods inflation has actually been negative, or deflationary). Additionally, they’ve acknowledged a key point that housing inflation has not only stopped, but is generally declining (this is true of both home prices to buy and houses and apartments to rent). Thus, they’ve correctly highlighted that because of the way the CPI is calculated for shelter, it’s going to lag current market conditions considerably (without getting into the nitty gritty here, it lags because it only captures transactions when people actually move or otherwise sign new leases, which people usually only do once a year, so this can lag what's happening on the ground by a year in some cases). What’s left then is this bucket of “services ex. Shelter,” and this is where the Fed has chosen to focus our attention over the last two months, particularly because it’s here where the labor market has its strongest influence. This is primarily because in services businesses where you aren’t selling goods, your largest cost is labor. Chair Powell and his Fed Comrades have repeatedly stated that services inflation ex. Rent remains too high, and they’ve used this as the key reason to talk the markets down over the last month, even though there’s a lot to be encouraged about in all three of these buckets, and even as the most recent jobs report provided further evidence recent trends in the wage market are improving nicely as well.
So, let’s have a quick progress report, with the most important bucket first (services ex. Rent). The first chart shows the contribution to the monthly inflation figure, and compares it to the pre-COVID average. What you’ll see is that for the last three months now, services ex. Rent have inflated at a rate that is below their pre-COVID average. Why is the Fed saying otherwise? Because they’re choosing (arbitrarily in my view) to look at this figure over longer horizons (6 and 12 months) to make the numbers look worse. Why are they doing that? Because they don’t want the stock market to go up, and they don’t want interest rates to go down. Why not? Because they fear that if the stock market goes up, you’ll feel richer and you’ll spend more money as a result. If that happens, it increases demand, and companies may feel emboldened to raise prices excessively again. Similarly, if interest rates start to fall again, it could encourage more borrowing and jolt the economy again just as inflation is getting under control. While its debatable whether the Fed’s obsession with these “financial conditions” is warranted or not, at the moment, they’re going to work this angle as hard as they can. December’s CPI report, however, is going to make it increasingly difficult for their “jawboning” to have any credibility.
Here are the key charts on services ex. Rent. Again, this is the contribution to monthly inflation (so our 0.3% core figure from above) from services ex. Rent.
Now here’s a chart showing total services contribution and services ex. Rent, to distinguish the two. You can clearly see the gap widening here, with services ex. Rent coming in from earlier this year (orange line), while the lagged rent figures remain very high (blue bars).
To show this figure more clearly, here’s a chart with just the contribution from shelter all by itself (for the avoidance of confusion here, I use “rent,” shelter” and “housing” interchangeably). Even though home prices and rents are finally coming down, because of the lag effect in how the CPI calculates shelter inflation, it’s actually showing prices are increasing at the fastest rate they have in years. While this is the complete opposite of reality, thankfully the Fed has acknowledged this. They’ve correctly stated that this gap is almost assuredly going to close starting later this year. But for now, this lag in rent has a large impact on the actual “headline” and “core” CPI numbers you read about every month, so it’s important to understand just how much rent is contributing. With Goods (again) contributing -10 bps this month (see the chart below), services ex. Rent contributing a positive 5-6 bps, shelter’s contribution is essentially making up the entirety of the increase in the core CPI.
With both goods and services ex. Rent inflation back in-line with pre-COVID levels, and with shelter inflation expected to come in later this year, how close are we to our 2% inflation forecast? Well, with goods basically back to zero, and services ex. Rent contributing a 5-6 bps a month (this is compared to its pre-COVID average of 7 bps, for example), those two categories alone account for about 60-70 bps of our 2% inflation target (figure a monthly contribution of 0 bps for Goods, multiplied by 12 months, which equals 0%, and 5-6 bps a month for services ex. Rent, x 12 = 60-72 bps annualized). If shelter prices in the market are currently flat at best (in reality like we said above, they’re declining), then it’s safe to say we can probably use the pre-COVID level of rent inflation as a conservative placeholder for now. That figure before COVID was about 11 bps a month, which on an annualized basis, amounts to about 1.4%. Thus, we have 0 from goods, 60-70 bps from services ex. Shelter, and 140 bps contribution from shelter. That adds to exactly 2%.
We should also remember here that the Fed actually doesn’t target 2% in the CPI. It targets 2% inflation in another inflation benchmark, which is the PCE (Personal Consumption Expenditures). Historically, and for reasons we won’t get into now, the PCE has been about 40 bps below where the CPI is (so if the core CPI was repeatedly printing 2.5% on an annual basis, core PCE would be in the range of 2.1%). Thus, “target” CPI is actually more like 2.4% rather than 2%. Said differently, using both the current month’s figures, any of the last three month’s figures, or better yet, an average of the last three month’s figures, you can reasonably say that we are actually back to 2% inflation today. In the last few months many of us have been eager to use each month’s results and annualize them to get a more accurate picture of what's happening currently, rather than using longer averages that bake in a lot of inflation that's already happened. But now we can not only do that, but we can use a three month average as well. This makes it all the more persuasive that the improvements we’ve seen are real. Here is another chart we have been showing with more detailed category level 3 month averages that indicates the same thing:
Now, you certainly won’t hear this from the Fed. They’ll be the last ones to declare victory, and that’s probably a good thing. What is concerning, however, is how long they will feel the need to keep “jawboning” the markets to convince everyone that we still have a major inflation problem. This political corner they’ve backed themselves into (something I’d argue they did needlessly way back in August at Jackson Hole) is the biggest threat to the economy, and now that they’ve decided that 5% interest rates is seemingly a floor of where Fed Funds should go, they’re going to have a difficult time adapting to the fact that the inflation data is getting better, faster than they anticipated. Because of all the political credibility they lost by not doing anything in 2021, there’s a huge risk now they try to stay tougher for much longer than they need to to make sure they don’t look weak again. The problem with that of course is that this political intransigence has significant repercussions for both jobs, and financial markets. This is the classic situation of two-wrongs-don’t-make-a-right.
Markets today are telling you the Fed is going to stop raising interest rates very soon, and will not likely make it all the way to 5% (today as a reminder, they’re at 4.25-4.5%). Contrary to what you’ll often read in the financial press these days, this isn’t because markets think the Fed is weak. Markets are telling you the Fed won’t get to 5% because it doesn’t need to, not because it doesn’t have the political courage to do so. But, because Fed officials left and right have tried to convince the markets that they’re going all the way to 5% (with many still indicating we need to actually go beyond that), the biggest risk now to both the economy and the markets is that the Fed tries to look so tough that they keep on raising rates regardless of the improvements we’re seeing in the data. If they keep trying to talk about 6 and 12 month moving averages instead of acknowledging more recent averages (like 1 and 3 month), that’s fine. But it’s one thing to talk tough, it’s another thing to act on it.
Because they’ve A) raised rates to such a high level and B) communicated ad nauseum that they aren’t going to cut rates anytime soon (which they again went out of their way to communicate in the most recent Fed minutes when they said that “no committee member expected to reduce rates anytime in 2023”), there’s still a significant risk that we have a recession in 2023 or in 2024, and as both an investor and as a person, one needs to very much keep this risk in mind. The Fed would do well to pause immediately, and I think if they hadn’t adopted their more vocal communication strategy they’ve employed all year, I suspect they would. But, in reality we’ll almost assuredly get at least one more 25 bps hike at the next meeting in a couple weeks. Between now and the March meeting though (two meetings away), we’ll get two more CPI prints, and if they look anything like any of the last three months, it will likely be safe to say the Fed is done hiking. Then we’ll have to deal with another political quandary they’ve built for themselves, which is when to start cutting rates. This was why I think it was beyond dumb for them to hike this far, this fast, in the way they did, simply because now they’ve not only boxed themselves in to 5% (or higher) near-term, but they’ve said over and over again that they don’t want to cut too quickly. Cutting too soon (“loosening policy”) is the key mistake of the 1970’s, we’re told. The best way to avoid that was by going slower on the way up, and not getting so high that you were forced to cut because you overdid it and produced too much economic pain. There's now a good chance the Fed is forced to repeat that path.
Therein lies our conundrum. The Fed has been largely successful in its inflation battle so far, and each ensuing month confirms we’re on track to get back to target very soon. As I’ve argued above, I actually think we’re basically already there. Because the Fed has said they’re going to 5%, however, reiterated that they’re going to stay there for “some time,” we still have two political challenges that they have to message their way out of. If it was only up to the data, one could start to feel very positive about stock market performance in 2023, and for increasing the odds that we avoid a recession and achieve our coveted “soft landing.” Because now we’re dealing with hubris and political credibility though, a chance for a big policy mistake unfortunately still exists.
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