Thoughts On ... Revisiting the Inflation Debate

January 13, 2023 | Matt Barasch


The main narrative of 2022 was that inflation had become deeply rooted and the only way to bring it down was for central bankers to aggressively raise interest rates. This led to an unprecedented rate hiking campaign by both the Bank of Canada and the U.S. Federal Reserve.

First, let’s consider the following:

The goal of raising rates is mainly to curb demand for stuff, which will cause businesses to invest and spend less, reduce hiring and ultimately lead to lower prices as supply begins to outpace demand. Ultimately, the goal is to get inflation back to ~2%, which has been both the target for the Federal Reserve (and the Bank of Canada) as well as the trend over the past ~2-decades:

As you can see, we can spend long periods of time either above or below the target/trend, but ultimately, the Fed (and the BoC) have successfully kept inflation near target for the past two decades. Obviously, they have been less successful in the past 2-years, which is what has prompted the extremely aggressive tightening. Okay, let’s now dig a bit deeper into the more recent data to get a better sense as to what the path of inflation might be in 2023:

As we have noted in the past, annual inflation changes from month to month as the data point from 1-year ago is replaced with the most recent month’s data. If the most recent month’s data is lower than the month it is replacing from a year ago, annual inflation will drop, whereas if the most recent month’s data is higher than the month it is replacing from a year ago, annual inflation will rise.

As you can see from the chart above, the “year ago” data points (in gold) were quite chubby, especially if we look at the fall of 2021 where monthly CPI averaged 0.65% from September through December. Contrast this with the fall of 2022 (in blue) where monthly CPI averaged 0.2% and it is not hard to see why annual CPI (the red line) is beginning to come down sharply. And here’s the good news:

As you can see, over the next 6-months, we have some very chubby monthly CPI numbers that we are going to be replacing. With monthly CPI now 0.1% or less in four of the past six months, it is not hard to imagine a scenario in which we are looking at annual CPI of less than half of current levels by the summer of 2023:

Thus, when we start to think about the end of the interest rate hiking cycle, it is not hard to imagine that most, if not close to all of the heavy lifting has been done. For its part, RBC Economics sees one more 25 basis point hike for the BoC at its January meeting and then a pause, while it sees the Fed raising either 25 or 50 basis points at its February meeting, followed by one more 25 basis point hike and then a pause.

Okay, before closing the book on this, we wanted to highlight one more thing that could be a potential driver of lower inflation as 2023 progresses – Owner’s Equivalent Rent (OER). We have discussed OER before, but basically, because ~2/3rds of Americans own their homes, there needs to be some way to measure this in CPI – so OER was created to essentially create an assumed “rental cost” to home ownership. Not surprisingly, OER is closely tied to home prices.

As we have noted in the past, OER rises and falls with a lag to housing prices. Generally speaking, if home prices start to stagnate or fall, OER will follow about 6-9 months later:

For the past four months, home prices have been in decline and with mortgage rates near 20-year highs, it is unlikely this trend is going to change over the next year. However, OER, which makes up ~25% of the CPI basket, continues to rise because it reflects data from 6-9 months ago:

Lastly (we promise), it is not hard to see the impact that lower OER (likely by the spring) will have on overall CPI:

Bottom Line: While it took us a while to get there, the bottom line is that absent some exogenous shock, inflation is very likely to come down sharply over the next 6-months. This should allow both the Federal Reserve and the Bank of Canada to bring their rate hiking cycles to an end. While we do not think rate cuts are likely in 2023 as both Central Banks will want to be convinced that inflation has been beaten, we think that investors will begin to look toward 2024 rate cuts and a normalization of interest rate policy as we get toward the second half of 2023. Thus, while our overall tone entering 2023 is cautious (although, the year is off to a good start), we do think that the set-up for the second half of the year (and potentially earlier) has the potential to be quite good.