The Slope of the Inflation Slide

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The Federal Reserve maintains strict rules prohibiting FOMC members from commenting on the economic outlook or monetary policy in the 10 days preceding an FOMC meeting or on the following day. Thereafter they are free to speak and over the last two weeks many have opined on both subjects. Their opinions show remarkable unanimity. They are focused on bringing inflation back down to their 2% target. They acknowledge the uncertainty in the economic outlook, and, as a consequence, they profess themselves to be “data dependent” and frequently quote, with furrowed brows, the year-over-year increases in CPI and consumption deflator measures of inflation.

However, data dependency can be carried too far. Monetary policy impacts the economy with a lag. So, for that matter, do fiscal policy and exchange rates. Any turn in year-over-year inflation rates, will, by definition, lag a monthly change in seasonally adjusted inflation momentum. In the long history of Federal Reserve mistakes, one general error stands out. They tend to wait too long and then do too much, and, in so doing, actually accentuate rather than tame the business cycle. 

They appear to be well on their way to repeating this error today. If they do so, they could inflict an unnecessary recession on American families, while doing little to improve productivity or living standards. That being said, however, such a recession would most likely be shallow and would give way to an environment of slow growth, low inflation, low interest rates and high profit margins – in short, a very positive environment for both bonds and stocks.

The Short-Term Inflation Outlook

On Thursday the Bureau of Labor Statistics will release the consumer price index numbers for September. We expect a 0.3% increase overall with the seasonally adjusted year-over-year headline rate falling from 8.2% to 8.1%. Excluding food and energy, we are looking for a 0.4% increase with the year-over-year rate rising from 6.3% to 6.5%.

While this would represent a continued slow drift down in headline inflation from its June peak of 9.0% year-over-year, both financial commentators and Fed officials are likely to declare this progress as being too slow. In addition, many will focus on the increase in year-over-year core CPI inflation to its highest level in the current cycle, surpassing its March reading of 6.4%.

However, beneath the surface there are plenty of signs of short-term progress. Food commodity prices, while up sharply year-over-year, have backed off from their springtime peak. Crude oil prices, despite last week’s OPEC production cut, are well below their mid-summer peak as are U.S. natural gas prices. In addition, wholesale used car prices and airline fares have fallen recently and a rebound in new car inventories, from very low levels, should relieve some pressure in this area also.

If we assume that a September headline CPI monthly increase of 0.3% is repeated over the following three months, then year-over-year headline CPI inflation will be below 7.0% by December.

Core CPI inflation may fall more slowly, from 6.5% year-over-year in September to 5.4% year-over-year in December. However, it must be emphasized that shelter accounts for almost 42% of core CPI and the owners’ equivalent rent part of this accounts for more than 30% of core CPI on its own. This is important for two reasons. 

First, both actual rent and owners’ equivalent rent lag the rest of CPI very significantly as they track the increase in rental costs for both new and existing leases. Even when new lease rates begin to fall, the year-over-year change in existing lease rates can remain positive. Recent research by the Dallas Federal Reserve suggests that the year-over-year increase in both actual rent and owners’ equivalent rent won’t peak until the middle of 2023[1] at levels of close to 8% year-over-year. 

Second, it is very doubtful whether the Fed should use this kind of inflation as a guide for monetary policy. Owners’ equivalent rent is an entirely nebulous concept. It is the rent homeowners would pay if they rented rather than owned their home. But since homeowners do own their homes, no economic harm is caused by rising owners’ equivalent rent.

The Longer-Term Inflation Outlook

While the Federal Reserve is waiting for more data showing actual declines in inflation, both leading indicators of inflation and macro-economic forces strongly point to lower inflation ahead.

• First, on supply-chain issues, as we show on page 53 of our Guide to the Markets, the global vendor delivery index and indices of input and output prices have all fallen sharply in recent months.
• Second, there are clear signs of a pullback in U.S. consumer spending. We expect this Friday’s September retail sales report to show a significant decline in ex-auto retail sales. If this transpires, it could imply less than a 0.1% monthly gain in real consumer spending over the last six months. Despite a sharp ramp up in credit card debt, the phase out of government pandemic programs have left many consumers strapped and we don’t expect any further relief in the form of fiscal stimulus between now and the 2024 presidential election.
• Third, the sharp increase in mortgage rates and the sharp surge in the value of the dollar should act as a significant drag on demand from both the housing and trade sectors in the quarters ahead.
• Finally, despite the market’s reaction to last Friday’s jobs report, investors need to recognize two important labor market trends. First, the labor market is gradually coming back into balance. As evidence of this, August saw a huge 1.1 million decline in job openings while the non-farm payroll gain for September, at 263,000, was the smallest increase since April 2021. Second, contrary to much market commentary on the subject, wage inflation cannot be accused of accelerating current inflation trends. The reality is that, assuming consumer prices rose 8.1% year-over-year in September, the 5.0% increase in wages over the same period can only be said to be slowing the decline in inflation rather than speeding it up.

Taking all of this into account, we expect year-over-year headline consumption deflator inflation of 5.4%, 2.7% and 2.6% in the fourth quarters of 2022, 2023 and 2024 respectively – not significantly different from the Fed’s forecasts of 5.4%, 2.8% and 2.3% over the same periods. 

Investment Implications

The strange thing about this forecast is that it isn’t particularly controversial. While some feel a sharp increase in the unemployment rate will be necessary to quickly reduce inflation to 2%, a balanced look at both current economic data and future trends suggests that it is headed in that general direction with or without even more aggressive Fed action or a recession. For the Federal Reserve, it will be important at their November meeting to acknowledge progress on the road to lower inflation and to begin to signal at least a slower pace of tightening. For investors, it’s important to recognize that the real question is not whether inflation is falling but the slope of the slide. Across a range of these possible slopes, there should plenty of opportunities for those investing in financial markets today, particularly given the sharp selloff across stocks and bonds triggered by fears of a worse inflation outcome and a more hawkish Fed than is likely to prevail in the coming years. 

[1] See “Rent Inflation Expected to Accelerate Then Moderate in Mid-2023” Xiaoqing Zhou and Jim Dolmas, Federal Reserve Bank of Dallas, August 2022.

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