Inflation – we can’t quit you

Not to beat a dead horse, but we will once again talk about inflation this week; although, we will focus this time on where we have come from and what possible glide paths could mean from here for the inflation outlook. Let’s first start with a chart and then comment:

Here we are looking at the U.S. Consumer Price Index (CPI), which stands at ~8.2% on a year-over-year basis. We would note that the target for inflation is 2% y-o-y, so at current levels, the U.S. is running at more than 4x its targeted inflation rate. As you can see from the chart above, when Covid first hit, inflation actually plummeted to close to the zero line as demand for services – travel, restaurants, etc. – dropped to zero, but then as the economy reopened in 2021, the combination of pent-up demand for services and massive government stimulus (plus a supply chain that was still damaged) fed a spike in inflation. While we were optimistic things would improve in 2022, the combination of still high demand for services and the Russia/Ukraine conflict fed a second, more nefarious rise in inflation.

Okay, now, it’s important to note that y-o-y inflation is essentially a function of month-over-month inflation for the past 12-months. Every month that we get a new data point, we drop the data point from a year ago to calculate the new yearly inflation number. So, for example, when August monthly inflation data comes out, we drop last August’s data point from the calculation in favor of the new one. Thus, it is useful to look at monthly inflation data to get a sense of how we are calculating the yearly number and what values will soon be replaced:

Now, there’s a lot to unpack from the chart above, so let’s take it piece by piece. The blue bars are monthly inflation over the past 12-months, whereas the gold bars are the monthly inflation data points from the year before. So, if we look at August of 2022, the monthly CPI increase was 0.1%, which replaced 0.3%, which was the monthly increase from August of 2021. Hence, the red line, which is annual inflation, actually drops in August (and July because we dropped 0.5% from the annual number in favor of 0.0%) because we are dropping a higher reading from a year ago in favor of a lower one.

We would note in the chart above that there are some really spicy month-over-month data points – with all months from October 2021 through June of 2022 save for April exceeding 0.4% and all months over that period exceeding their counterpart from the year before again save for April.

Now, this does not paint a particularly pretty picture, but it does potentially tell us some things about the glide path of annual inflation from here:

• The last two months have been promising as July’s monthly change was 0% and August was 0.1%;
• Inflation would have to be really hot from here on a monthly basis for inflation not to come down sharply over the next 10-months as we are going to be replacing some really spicy months.

With that in mind, let’s look at what would happen to annual CPI under three different scenarios: 1) we continue the August trend and CPI comes in at 0.1% monthly over the next year; 2) inflation picks back up to 0.2%; 3) inflation picks up to 0.3%. Now, some may ask – why not higher than this? The simple answer is because we have already seen a marked slowdown in the economy. Demand for goods is dropping sharply, while services demand has begun to feel the pinch from higher prices. The likes of Walmart, Target, Fedex, et al  are telling us that the economy is in rough shape and as we have noted in past missives, demand is one of the single biggest drivers of inflation. There is also another reason, which we will touch on in a moment.

Okay, with that out of the way, let’s look at what happens to inflation under those three scenarios:

As you can see, if we repeat the August experience (0.1% m-o-m) over the next year (the green dotted line), annual inflation will be below 3% by May of 2023 and below 2% by June of 2023. If inflation picks back up to 0.2% m-o-m and stays there, we will be at ~3% by May of 2023 and ~2% by June. Lastly, if we cannot shake inflation and it rises to 0.3% and stays there, we would still get to ~3% by June of 2023; although, we would eventually settle in at around 3.5%. In other words, inflation is going to come down absent some new unforeseen shock (likely from the supply side as demand is unlikely to surprise to such a degree that it leads to an inflation spike).

And, while this is good news from an investor perspective (and just from a regular perspective as well), where we ultimately settle matters a lot. That is – getting to the gold or green scenario would be very positive from an investment perspective as it would allow the Federal Reserve and Bank of Canada to declare that inflation is once again at or near their targets and no more interest rate hikes are necessary; whereas, the red scenario, while demonstrating a marked drop in inflation, would still be well above that 2% target and would likely keep both central banks on a tightening path.

Okay, we promised one more reason inflation is likely to drop, so let’s look at a chart and then comment:

Here, we are looking at something called Owners’ Equivalent Rent (OER). Whether one rents or owns a home, shelter is one of the biggest monthly outlays that a family has. However, home ownership is considered capital, not consumption, so everything a home owner spends on his/her house – mortgage, property taxes, maintenance, home improvements, etc. – is not included in CPI as CPI only looks at consumption. In order to remedy this, OER was created. OER basically says – if you had to rent the house you live in instead of own it, how much rent would you have to pay? As home prices rise, OER rises, usually with a bit of a lag, while when house prices fall, OER falls. We should also mention that OER is ~25% of the CPI basket, so every 1% change in OER has a 0.25% impact on CPI. In August, OER was up 0.71%, which means that the other 75% of the CPI basket was actually down 0.11.

Now, as you can see from the chart, OER has been rising sharply over the past year. This has been driven by a sharp rise in home prices with U.S. home prices up ~20% from June of 2021 to June of 2022. This has begun to change with prices recently flatlining and very likely to come down, perhaps markedly, over the next 12-months as rising mortgage rates (mortgage rates in the U.S. have more than doubled over the past year) and a slowing economy (not to mention high prices) weigh on demand and prices. This will, in turn, lead to a decline in OER, which will, in turn, feed into declining CPI. The one catch to this is that as we mentioned, there is a lag. Thus, while OER will come down and likely even turn negative at some point, it may take a few months before we see this.

Final Thoughts: With significant tightening of monetary policy, falling demand, the sharp drop in gasoline prices and ultimately declining OER, we are confident that the inflation picture will improve markedly over the next 6-12 months. Where CPI ultimately settles (~2% or lower in our green/gold scenarios, >3% in our red scenario) will matter a lot as it will dictate not only when and at what level the U.S. Federal Reserve and the Bank of Canada can end their tightening campaigns, but also the pace and timing of when they can begin to loosen monetary policy once again. While we remain cautious at the present time,  we do think that the very negative reaction to the 0.1% August CPI increase (an increase that if replicated over the next 9-months would see CPI at ~2% by May of 2023), is an overreaction given the drivers of this increase (OER).