We have written a fair bit on inflation over the past year and most of the news has been negative. We have also harped on the flawed way that inflation is measured with the Consumer Price Index (CPI) acting as the key metric for the Federal Reserve and for investors; despite, a number of limitations to CPI as a useful tool. This week, we saw the two come together in a positive way, driving a sharp market rally on Thursday. Let’s start with a chart and then comment:
What are we looking at? The gold bars represent where monthly inflation was a year ago, while the blue bars represent where monthly inflation is now. So, when we look at October’s data, we can see that last October (the gold bar) monthly inflation was 0.9%, while this October it was 0.4% (we would note that expectations were for a monthly increase of 0.6%). Thus, when we calculate yearly inflation (which obviously looks at the past 12-months), we are replacing 2021’s 0.9% October reading with 2022’s 0.4% October reading. As a result, annual inflation fell from 8.2% last month to 7.6% this month.
Now, as you can see from the chart, we have now had 4-consecutive months in which we have replaced a higher reading from a year ago with at least the same reading (September) or lower (July, August, October) number. As a result, yearly inflation, which was 8.9% in June, is now down about 15% to 7.6%. In fact, since June, monthly CPI has averaged ~0.2% per month, which is a vast improvement over the prior four months when it averaged 1.0%. With that in mind, let’s look at a second chart:
So, what are we looking at here? As we mentioned, annual CPI really just involves replacing the oldest data point (12-months ago) with the newest and re-running the annual result. What the chart above imagines is what would happen if monthly CPI kept hitting a consistent level – what would that force the annual number to do?
As you can see, if we simply repeated October’s (and September’s) 0.4% monthly reading, CPI would fall to around 4.5% in May 2023 before climbing to about 4.9%. Similarly, if the monthly data reverted to the average for the past four-months (0.2%), CPI would fall to ~2% by May of 2023 before climbing to about 2.4%.
Now, while the market celebrated the 0.4% result on Thursday (again, expectations were for a higher reading), we would note that were monthly inflation to settle in that 0.4% range through next year, it would likely be met with significant negativity amongst investors. Why? Because the U.S. Federal Reserve has a targeted annual inflation level of 2% and monthly readings of 0.4% are obviously not going to get us there. So, while 0.4% was positive in the context of a market that was expecting something much higher, we do need to see significant improvement from here to declare the inflation crisis at an end.
However, the 0.2% average we have seen over the past four-months would get us much closer to that 2% target, so we are trending in the right direction, albeit unevenly. Thus, while we remain generally cautious, we do see some signs that the headwinds we have faced over the past year are beginning to ebb.
Looking under the hood – the final point we would make is that it is always important to look beneath the hood of economic data as the headlines do not always tell the full story. In the case of CPI, this is especially the case as there are lots of weird inputs and outputs that can skew the data.
The Federal Reserve and the Bank of Canada are raising interest rates in large part because they are trying to bring down certain aspects of CPI. Things such as food and energy will tend to be insensitive to interest rate changes, but things such as cars and clothing will tend to be more sensitive. With that in mind, we can look at the CPI data and “strip out” the stuff that is not all that sensitive to interest rate changes to get a sense of how the interest rate sensitive stuff is acting following the sharp increase in rates over the past ~six-months. Let’s look at a final chart and then comment:
As you can see, while three large components rose quite sharply, the stuff that interest rates can directly impact (save for Shelter, which we will touch on in a second) actually deflated by 0.1% in October. Now, we assume that Central Bankers can parse the data in the same way we can and this is evidence that their efforts are working, which should at least begin to slow the pace of rate hikes over the next few months. Further, while Shelter does get impacted by rates, we would note that because of the way they measure the shelter data, there is generally a lag of about six to nine-months between when house prices fall and the CPI data picks it up. We have seen house prices fall over the past four-months, so while the Shelter component of CPI continues to rise, it is only a matter of time before it too will begin to print much lower numbers.