June CPI was the most encouraging CPI report we’ve seen in a long time (at least since Aug. 2021), with both headline and core inflation again showing meaningful progress. The last few months we’ve argued that despite what Fed officials and the financial press keep saying, we are probably close to the Fed’s 2% inflation target right now. Today’s report provides substantial additional evidence that this is the case. At worst, it’s becoming increasingly difficult to argue that we’re not at least “on the path back down to 2%” like the Fed wants. If this report, along with other reports seen during the last three months, aren’t enough for the Fed, it’s not clear what will be enough. Let’s review.
June headline and core CPI came in at 0.2% month-over-month, both seasonally adjusted. Unrounded core CPI was 0.17%, the lowest monthly increase since August 2021 (0.10%). This was better than consensus expectations for about a 0.3% increase in the core. As a reminder, Core CPI excludes Food and Energy prices, which tend to be more volatile (the Fed also excludes these items because Core CPI tends to be a better predictor for where future headline CPI will go as well). On a year-over-year basis, headline CPI increased 3.0% in June, which was the smallest increase since March 2021. Core CPI increased 4.8% year-over-year, the lowest since October 2021.
While these 0.2% monthly increases annualize to a rate close to the Fed’s 2% inflation target (0.2%^12 = ~2.4%, and recall CPI is typically about 40 bps higher than the Fed’s preferred inflation measure, the Core Personal Consumption Expenditures price index), more important than the aggregate 0.17% core CPI reading is how we got there. For the month, goods contributed -3 bps, services ex. Shelter (so called “core services”) contributed 3 bps, and shelter itself contributed 17 bps. Notably, used car prices actually contributed -5 bps this month, after contributing roughly positive 15 bps in each of the last two months. Even despite this inflection in used car prices, however, goods inflation was encouraging almost anyway you slice the data.
The below 3 charts I think do a pretty solid job showing that either on a 1 month basis, 3 month basis, or now, a 6 month basis, we’re arguably at 2% inflation today, and at worst, we’re “on the way back down to 2%.”
What the above three charts show is that 1) both core goods and core services (services ex. Shelter) are back to pre-COVID levels, and in the case of core services we’re actually below pre-COVID levels 2) shelter’s contribution (this month 17 bps) is still above pre-COVID. We’ve talked in recent months about how the CPI’s method of calculating shelter produces a lag, and thus, with shelter prices in the real economy much closer to flat for a while now, most people expect the shelter component of CPI to continue to fall in coming months. If shelter continues to come in, which would simply be following the trends in the real economy, and core goods and services continue to do what they’ve done the last several months, then we should continue to see CPI reports similar to today, and possibly even better. If that plays out for even another few months, there is simply no more need for further interest rate hikes. Period.
The below chart shows what inflation would look like if you normalized for the lag in shelter. On a one month, three month, and now six month basis, adjusting for the lag in shelter, we can see that we're darn near close to 2% today. This takes the average contributions from goods and services ex. rent on a 1, 3, and 6 month basis, and then factors in the pre-COVID shelter average (11 bps a month). All of this is annualized to produce an estimate of "current" or "run-rate" inflation.
Additionally, while goods have been more inflationary than expected during 1Q23, 2Q23 has looked a lot more like 4Q22. Notably, the bulk of the increases seen in goods in 1Q23 was because of used cars, which have now receded again (this month used car prices decreased -0.5% in the CPI, and as noted above, contributed -5 bps versus contributing +14 and +15 bps to core inflation in each of April and May). CPI tends to lag Manheim’s Used Car indices by a couple months, and Manheim has been showing declines for several months now, with June's decline significant (https://publish.manheim.com/en/services/consulting/used-vehicle-value-index.html). This suggests the used car component of the CPI is likely to be negative for at least the next several months. Although it’s seemed to do so at a glacial pace, the auto industry does continue to normalize, so while we could see used car prices spike again here and there, it’s unlikely they will appreciate notably from here. Consumer spending has clearly softened in recent months, and interest rates have moved back up (though this may start to reverse if we get more inflation reports like we did today). Thus, it feels increasingly likely that we’re on our way back to pre-COVID new and used car inflationary trends, which, similar to other goods, was quite low (per the charts below, 3-13 bps a month, which annualizes to 0.36% - 1.56% compared to overall goods inflation of about zero). If car price volatility continues to die down as we continue to get back to normal, we can probably stop talking about cars separate from other goods again, since car prices historically tended to act much more similarly to other goods than they acted differently.
We also continue to see the disinflationary trends when looking at median and average changes across category baskets. As we normally do, below are familiar charts showing median and average price changes across 55 baskets of goods and services that make up about 98% of the CPI. By looking at averages and medians of various baskets, we can get a better measure of inflationary breadth. If fewer number of items are increasing at faster rates, it’s likely that inflation more generally is slowing down, and that’s exactly what we see. The median and average category figures too are very encouraging, and are also indicative of inflation not only being back to pre-COVID levels, but arguably at 2% today. At worst, we’re “on our way back down to 2%.”
Now here’s the above metrics on a 3 month annualized basis.
The lines continue to be well below the bars, which is primarily because of the issue with the shelter component of CPI discussed earlier. If you exclude shelter and look at the changes in the typical item in the CPI, we see inflationary breadth considerably lower, and I would argue, very much in-line with 2% inflation.
Now we’ve been head-faked before (July 2022 and then in 4Q22 are good examples of this), only to see a reflationary surge in the first quarter of 2023. But what we saw this month was more than just one month of good data. It was a continuation of trends we’ve seen in recent months, along with what will likely be continued moderation in the shelter component. While it’s certainly possible this month and recent months will be another headfake, it seems more likely than not that this won’t be the case. The key difference between now and 1Q23 is that consumer spending has slowed considerably since the surge earlier this year, which may have been largely due to Social Security resets from Cost-of-Living adjustments. Furthermore, with student loan payments poised to resume in 4Q23, and with the labor market continuing to cool, it feels more likely that consumer spending will slow further from here rather than accelerate. While further deceleration puts recession risk further back on the table, it should also help ease inflationary pressures further, and probably force the Fed’s hand to cut rates rather than simply stop hiking them and hold them in place. More on that in a minute.
In conclusion, the inflation data continues to show good progress, so much so that it’s becoming easier and easier to argue that we’re well on our way on our path “back down to 2% inflation,” if not already there. But while this is the case, the Fed has spent the last month or so trumpeting how more rate hikes are needed to quell inflation. Financial markets have generally, though not entirely, treated recent Fed “jawboning” as just that, posturing. Markets have generally been of the view over the last few months that tough talk from the Fed was more a function of them not wanting to roll out the “Mission Accomplished” carpet too early, even though the inflation data has clearly gotten better. That’s all well and good, but this tough talk seems to have grown into something more than that in recent weeks, and culminated with a jolting new interest rate forecast at last month’s June Fed meeting. Part of this difference in outlook seems to stem from the notion of what the right inflation metric to look at is. Should we look at monthly increases and annualize them? Or should we continue to look at year-over-year changes?
For a Fed who wants to continue to look tough on inflation, harping on the year-over-year changes is the easy metric to cherry pick. That still remains “elevated” well above their 2% target. Most people also tend to look at this figure, as does the financial press. But as we’ve argued here for a while now, looking at year-over-year changes unfairly weights inflation that has already occurred 9-12 months ago. If you’re living in an apartment, and they raised your rent last year by 5%, but all your neighbors who have recently renewed their leases have been able to do so without any increase, then you are unlikely to care about the year-over-year change. The "market" rate of change is flat. This is broadly how most prices in the economy work. They fluctuate seasonally, but they don’t tend to ever decrease on a year-over-year basis. Instead, they tend to increase modestly. It's only been in the last couple years where we've seen this trend break from its historical average.
Because prices 9-12 months ago are already baked in the cake, during periods where inflation is increasing or decreasing at a faster clip, it’s better to take more recent trends and annualize them rather than looking at the year-over-year trends. But because the Fed can conveniently look at the year-over-year figures to support their posturing, they’re arbitrarily choosing to use that as the key performance indicator. Even some of the Fed’s own indicators, however, such as the New York Fed’s Underlying Inflation Gauge, show that “run-rate” or “trend” inflation is much better than the year-over-year figures suggest (https://www.newyorkfed.org/research/policy/underlying-inflation-gauge). “The UIG 'full data set' measure for June is currently estimated at 3.2%,” the New York Fed said yesterday, and "The 'prices-only' measure for June is currently estimated at 2.5%.” This is much better than the 4.8% year-over-year figure the Fed and everyone else seems to prefer to talk about. This also says nothing about the trend in these more near-term based metrics, which as you can see from the chart below, is sharply decelerating. This too points to us either being "on the way back down to 2%" or already there today.
There is also something else going on. Since late last year, there has been confusion and conflation around the notion of what “tightening” and “easing” monetary policy is (which is broadly characterized as the level of interest rates set by the Fed). People often conflate holding interest rates steady with cutting interest rates, implying that both are somehow easing policy. Frankly, Fed officials themselves often add to this confusion. Just yesterday after the CPI data, Richmond Fed President Thomas Barkin stated “Inflation is too high…If you back off too soon, inflation comes back strong, which then requires the Fed to do even more.” But by presenting it that way, he conveys a message that people are asking the Fed to cut interest rates. This is not the case. People simply think they need to stop raising interest rates. Cutting and not raising are not the same things. No one is saying they need to back off right this second and lower rates (though as we’ve showed above, you could probably argue they could do that). People are simply saying stop the hiking.
The Fed (finally) paused interest rate hikes in June, but even after yesterday’s CPI report, they seem convinced they’re going to hike again in July’s meeting next week. Given the Fed just revised its economic forecasts in June (needlessly in my view), Chair Powell will again have to answer questions about what the Fed will likely do with their inflation forecasts at the upcoming September meeting. At worst, one would hope he’d signal to everyone that the Fed is probably done hiking rates, but not necessarily going to cut them anytime soon. That would be the right thing to do. The Fed should do nothing next week, but because it’s already publicly beat the drum so hard the last month, it probably will hike rates 25 bps again to maintain this amorphous concept of “credibility.” After that, should the economy continue to hold up as it has, and we get more inflation reports like we’ve gotten today, an extended pause would be very much in order, and probably wouldn’t even be controversial. Whether they do that or not, however, will remain to be seen.
This source of uncertainty is exactly why markets have repeatedly priced in rate cuts over the last year or so (in addition to real fears caused by shocks to the economy like we saw in March from the SVB crisis). This has been another source of confusion over the last year or so. The financial press, and even many Wall Street strategists, have repeatedly been mystified why markets have been pricing in interest rate cuts over the last year and a half despite the Fed saying they weren't going to cut. Contrary to what you often hear on Bloomberg and CNBC, this IS NOT because the market “doesn’t believe the Fed,” but rather because markets think the Fed is going to screw up and raise rates too high, thereby causing a recession (which will then drive the Fed to cut rates). Again, these are not the same things, and the press’ inability to clearly understand this dynamic adds to confusion. The Fed doesn't think it's going to raise interest rates too far and cause a recession, but it never does. Of course it doesn't think it will need to cut rates then. But the Fed's track record, however, indicates otherwise. Thus, the market does worry about this, and that's why they have repeatedly priced in cuts over the last year.
If Chair Powell comes out next week and reaffirms the hawkish tone he and his comrades have conveyed over the last month, even after today’s CPI report, it will likely spook markets back into thinking they’re going to do what they usually do, which is overhike and put the economy into recession. The economy is thankfully strong enough that the Fed has more cushion now to protect against a screw up, fortunately for us. The Fed’s job is thankfully getting easier, we’ll see next week if they make it harder on themselves or not.
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