The Full Story:
The Federal Reserve began hiking interest rates off the zero-bound trajectory in March 2022. At the time, consumer price inflation was running above 8%. Many accused the Fed of being “behind the curve,” as they clearly were:
Recognizing the cost of their delay, the Fed increased the benchmark interest rate by 5% over the next 15 months in one of the most aggressive monetary tightening cycles in history. The combination of natural disinflationary forces and monetary austerity has driven dramatic results. On Wednesday, the US Bureau of Labor Statistics released the June Consumer Price Index report showing headline inflation has declined from 9% last June to 3% this June. Markets rallied strongly on the news as less inflation means less Fed and less Fed means less recession. Given the Fed’s 2% inflation target and the clear downward momentum within the report, it’s right to ask, is the Fed finished?
Gimmie Shelter Disinflation
While headline inflation rose a comforting 3% over the past year, it’s core inflation that discomforts the Fed. Core inflation lies well above the Fed’s 2% comfort zone at 4.8%. Therefore, to divine what’s in the Fed’s head, we must become conversant with the core.
Core inflation represents 80% of headline inflation and contains everything households purchase besides food and energy. Of the 80%, housing inflation accounts for roughly half of the total, with new and used vehicles accounting for the next highest contribution at only 7%. The rest of the components consist of everything from household appliances to wine (at home and away from home). For those who prefer the trees to the forest, you can find the itemized report here.
Within the CPI report, housing-related inflation ticked slightly lower but remains 8% higher than year-ago levels. Given the outsized role of shelter within CPI, the vast majority of inflation within the report was housing related. In fact, if you strip out housing, headline inflation falls to 1.7%, and core inflation falls to 2.7%, well within the Fed’s target range. This chart depicts just how dramatically overall inflation has risen and fallen when excluding shelter inflation:
To further illustrate the rapid fall in price levels afoot, 45% of the items measured in June experienced outright deflation! With shelter sheltering inflation, when will these levels leg lower? Unfortunately, shelter inflation calculations in the CPI report arrive with considerable lags. Considering that the three-month rolling average shelter inflation rate is 6% and the June monthly rate annualizes at 4.4%, shelter inflation could fall more quickly than anticipated. Economists often reference more real-time gauges of shelter inflation like the Zillow Rent Index. Some have observed that the Zillow index tends to front-run the CPI shelter index by about one year. The Zillow index peaked early last year and recently reported rent inflation of 4% in June. The following chart harmonizes the two inflation indices and adjusts for the 12-month lag:
Well, isn’t that encouraging?!
If these proportions hold, shelter inflation within the Consumer Price Index could return to the Fed’s target levels within 12 months. With shelter’s outsized influence, shelter disinflation means deflating recession conviction at the Fed. Furthermore, stocks historically return three times more for investors when CPI falls than when it rises.
So, will this report keep the Fed at bay? Likely not. They have set expectations that they will raise rates another .25% on July 26th. Powell will undoubtedly site elevated wage inflation and “supercore” inflation that remains well above the 2% target. But even that fallback measure has lost momentum, as seen below:
In sum, we expect one more face-saving hike from the Fed with empty threats of doing more. Remember, while the Fed may have a 2% target for the rise in general price levels, the long-term inflation CPI inflation rate for the USA is 3.5%, above where we are today. The Fed may remain a problem, but only if they fail to recognize that inflation no longer is.
Have a great weekend!
David S. Waddell
CEO, Chief Investment Strategist