Have We Finally Tamed the Beast of Inflation?
Finally, some good news Tuesday on the inflation front that investors may be able to rely upon.
May’s Consumer Price Index increased by 0.1% on a monthly basis and 4% over the last year, the lowest annual rate since March 2021. Core CPI (excluding food and energy) rose 0.4% monthly and 5.3% annually. As an aside, we find this core measure somewhat perplexing as an indicator of price stability since it excludes the items that are the biggest percentage of the average consumer’s budget after housing. (Source: Bureau of Labor Statistics)
Back in August 2022 (Is the Market Crying Wolf on Long-Term Inflation?), we argued that inflation might follow a similar post-COVID pattern as many other market variables.
Despite attempts to compare the experience to previous economic and market periods, mostly confounding supposed logic at every turn, a familiar pattern unfolds. First, there’s a run-up based on real and perceived trends. Next, things stabilize for a period at higher levels. Finally, a massive pullback occurs when it’s obvious the circumstances causing higher expectations are fading… Maybe there is something similar happening with inflation.
Since our August blog, we have seen disinflation take hold after a period of price stability. However, as evidenced by the chart below, not all components of CPI are created equal. While Flexible CPI (faster to change components) has rolled over dramatically, essentially in line with the supposition above, Sticky CPI (slower to change components) has only recently started to roll over and decline.
We may have found a culprit – “greedy” companies that have continued to raise prices and test their pricing power even as input costs have moderated. A recent article in the NY Times (Companies Push Prices Higher, Protecting Profits but Adding to Inflation) suggests that investors are now more focused on volume gains over gross revenue as an indicator of secular growth as pricing power wanes.
Welcome to the party.
In December 2022, we pointed out that companies were using higher input costs as de facto air cover to increase prices. (Is inflation no longer the Bogeyman?) We wrote:
Over the last six months, companies have scrambled to raise prices justified by supply chain issues and input and wage pressures. But they did not stop when they reached equilibrium – often pushing prices higher and enhancing margins because they could. As supply chain issues have eased and input prices have declined, have companies lowered their prices? Not yet. But as volumes wane, they may be faced with lowering them very quickly, accelerating the decline in inflation.
After a cumulative 5% increase, for the first time in 15 months, the Fed did not raise the Fed funds rate, opting instead for a hawkish pause, or a “skip”. Instead, they let a new “dot plot” and a hawkish presser by the Fed Chair do the heavy lifting. Although not official, this simple form of data visualization suggested two more 25 bp rate hikes before year-end and no rate cuts, meaningfully different than market expectations. According to Bloomberg, Fed watchers remain skeptical of the Fed’s resolve with only a slight increase in the probability of a July rate hike (now 62%) and a peak rate of 5.3%, not the 5.5% indicated in their dot plot. And they are still holding out for rate cuts beginning in December, although with less confidence.
Despite all the good inflation news, employment remains stubbornly strong, and that matters to the Fed. Again, back in December 2022, we wrote:
In Powell’s question and answer session, he indicated that the Fed is partly shifting its focus to employment as a proxy for success in bringing inflation to heal. In other words, only higher unemployment rates will quell wage inflation, the most impactful and stubborn component of inflation…. Powell seems intent on breaking their collective will and forcing them back into the labor market, thereby subduing overall wage inflation with a greater labor supply.
How does the Fed now reconcile higher employment and inflation? Eventually, we think by revisiting the assumptions that link employment, wage increases and higher consumer prices.
A recent (6/12/23) article from Bloomberg (Fed Backs Away From Wages Focus, Bolstering Case for Rate Pause) suggests that there is growing consensus inside the Fed and among economists that the previously assumed direct link between wages and prices may be more complex than once assumed.
It is much better to have a data dependent Fed – not everything needs to be telegraphed in detail to “not spook” investors. We are big kids; we can handle some uncertainty.
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