October CPI finally started showing some of the lower inflation we had been talking about being "in the pipeline" over the last several months, with core CPI up 0.3% month-over-month and seasonally adjusted (which produces annualized core inflation of about 3.6% vs. the Fed's target of 2.0%) versus expectations for an increase of 0.4-0.5%. Headline CPI also came in better than expected at 0.4% M/M SA versus expectations for a 0.6% increase. This was a major sigh of relief, and gave the stock market--which had been coiled like a spring coming into today--rocket fuel for one of its best days in a long time, with the Russell 2000 up over 6% and the Nasdaq up over 7%. Treasury rates fell ~30 bps across the curve, also a huge move. Fed Funds Futures are now pricing in a much higher chance of a 50 bps hike at the December meeting (85% chance according to market pricing), with Fed policy by July 2023 about one hike (25 bps) lower than the end of last week. The markets are now telling us inflation is likely on a much better path from here, which will give the Fed a greater ability to stop hiking sooner (and with fewer interest rate increases in tandem) than we previously expected. This is good news.
The question is, is the market right? Or is October's CPI surprise release another headfake like July's? While it's hard to be certain about anything these days (the elections are another good reminder of that), there are some meaningful differences between today and July that make it more plausible that we're finally on a better trend. Here's a few:
After being essentially zero in September's CPI, Goods inflation was nicely deflationary in October, meaning goods prices actually went down over the last month. Though goods inflation was still coming down in July, it was still higher than today. The stubborn categories we talked about in prior posts (mostly home furnishings and used car prices) appear poised to finally crack, and there is good reason to think that will continue over the next few months, as financing in both of these key markets remains almost prohibitively expensive and inventory (though more so in cars than housing) continues to pile up.
While retailers got caught with too much inventory earlier this summer, and discounted heavily in June and July to move it, its clear consumer goods demand has weakened further in the ensuing months. Most retailers still have too much inventory, so with consumer demand where it is (Amazon's disappointing second prime day in October was a good indication of this), most retailers are fearful of a tough holiday season. This will make it unlikely (though certainly not impossible) that prices revert back to their increasing ways in most goods categories anytime soon. We may be very close to being back to "normal" here.
Key services categories outside housing showed nice improvement in October, especially in Medical services and transportation services. While transportation services is more of a wildcard, as discussed here (https://podcasts.apple.com/se/podcast/omair-sharif-explains-how-inflation-measures-really-work/id1056200096?i=1000534079388), the mechanics of medical services inflation should result in a continued tailwind for some time in this key category.
Housing's contribution to inflation actually got worse this month (indicative of the lag effect in those components in the CPI, but also indicative of the rest of services being that much better, as we'll show in a moment), but with home prices and rents now falling, its likely that that trend is likely to inflect sooner too (another positive).
Additionally, in contrast to July, the world has now had 8 months to digest the Ukraine / Russia war, and the economic ripple effects from it have largely been absorbed (though not without considerable impact in some cases, see Europe) compared to only 3 months of adjustment in July. While negative surprises here are always possible, the world seems to have baked this crisis into our daily life, with some of the worst impacts now even starting to reverse.
Companies have had that several more months to hire the workers they need, digest the wage increases, and price accordingly. With private sector jobs now above where we were pre-pandemic, and the labor market showing nice signs of cooling, one of the major cost pressures businesses were facing has now really slowed down. This doesn't mean it's no longer a cost pressure, but rather, less of a pressure than its been. We're fully in a world of second derivatives now, where the "change in the change" is more important in many cases than the level of change itself. In conjunction with supply chain costs also coming down, reduced pressure in the labor market makes it less likely businesses will have to keep raising prices (or at least not as fast and as much) to "catch up" with rising costs as they did earlier this summer, when both supply chain and labor were more expensive. This should also lead to more subdued consumer price increases in upcoming months, in theory anyway.
In summary, there's good reason to hope that October's surprise will not be a repeat of July's headfake. Goods inflation is likely to remain subdued in coming months, and may even remain deflationary as consumers continue to shift their spending away from goods to services. Importantly too, and as we'll show below, the goods deflation this month was not just driven by used car prices, nor was the CPI "beat" only driven by that either. The median and average category increases in our Sub-Indent 4 (recall this is 55 categories of goods and services that make up about 98% of the core CPI) was essentially zero this month excluding new and used cars. Furthermore, key services categories outside of housing appear to be inflecting positively, and an inflection in housing costs is also on the horizon. With people back to work now and layoffs picking up, this will likely keep the labor market in a more balanced spot. Coming into today, you could hold most categories inflation levels constant outside of housing and cars, and if those two items alone got better, I estimated we could see consistent 0.2's and 0.3's from core CPI by February or March. Today's print makes that forecast more achievable, but time will tell. In the meantime, have a great weekend, and enjoy the charts below!
Here's a chart of core CPI's aggregate index versus the 55 goods and services baskets measured in Sub-Indent 4 that we discussed above and in previous posts. Similar to July, the average increase in these 55 categories was actually negative (-0.02%), while the median inflected nicely lower too (0.2%, below July's 0.3% there too).
A deeper category analysis (Sub-Indent 5, which comprises 101 goods and services categories comprising about 78% of the core CPI index) shows a similar dynamic.
Here's the 3 month trend of each category level, annualized, versus the index. Note the gap between the index and the categories, suggesting the index continues to be held up in an outside way by things like rent. The categories continue to move in the right direction, suggesting inflation "breadth" is declining.
Here's arguably the second most important charts of the week, which is goods versus services contribution both including and excluding housing. This month saw the contribution from housing get worse, indicating most other things got better, on average.
Now here's the chart excluding rent. As we'll show in a moment, many services categories appear to be back to inflating closer to their pre-COVID levels. With housing likely to follow suit soon, services in general should continue to come in.
Lastly, here are some charts showing contributions from key categories. Note the marked change in Home furnishings and supplies, cars, and medical care.
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