There is a particular practice in financial markets: expressing shock when economic data does not match forecasts that few people initially trusted. This is what is currently happening with American inflation.
Core CPI growth for March last week came in at 0.359 percent month-on-month, compared to consensus of 0.3. A “huge” increase of 0.059 percentage points. This is a sign of a frenzied reassessment of the US Fed’s expected rate cuts for 2024.
Certainly, this is the third consecutive reading above expectations. So it’s entirely reasonable to think that the Fed’s stance on three rate cuts for 2024 could change (Powell suggested as much on Tuesday). But it seems a bit wrong to base rate reviews – going from 3 cuts to 1 or no cuts – on a series of missed inflation forecasts that few people had confidence in anyway. The best is to understand Why it came higher than expected first.
The chart below shows the contribution of the different components to annual US CPI inflation. Housing (housing) was a determining factor, and to a lesser extent, transportation. Both are responsible for the surprises in the monthly data for January, February and March. They help to make up the sticky services component.
Digging further, housing is itself determined by the “equivalent rent of the owners of the residences”. This is the BLS’s estimate of what homeowners would pay if they rented their homes. It represents a significant 34 percent share in the core CPI (which excludes food and energy). Auto insurance rules the bar for transportation services.
So what? The calculations of the REL are doubtful (it is imputed on the basis of rents for comparable rental accommodation). The EU HICP and the UK CPI – targeted by the ECB and BoE respectively – exclude it. As Andrew Hunter, US economist at Capital Economics, says:
Much of the current debate about inflation in developed markets is based on comparing apples to oranges.
(There might be another problem: circularity. Moody’s chief economist Mark Zandi says housing supply is constrained by tight monetary policy, which drives up rents and thus OERs. Also , higher insurance claim costs – which may themselves be due to inflation – can increase premiums (But that’s for another time.)
Regardless, the Fed targets PCE inflation. This measure places less importance on OER (the basic PCE only gives it a weight of 13 percent). It also measures insurance inflation net of losses.
Below is the annual inflation in the United States based on CPI, HICP and PCE. As you can see, measures with less emphasis on OER are much closer to the goal. And there’s a headline you don’t see: US inflation is actually the same as the Eurozone (comparing like-for-like)
But surely the CPI still reflects the price growth experienced by American households? This is true, to a certain extent. But as Paul Donovan, chief economist at UBS Global Wealth Management, says: “Because OER is completely invented, the real cost of living for a homeowner is more innocuous than the headline CPI would have us believe.” (Many market participants already know this, but it can still cause volatility).
Even if you are still committed to CPI, should to come down. RELs tend to lag private rent indicators – see chart below. Insurance also works on rolling contracts. Right now, auto insurers may be increasing premiums to offset higher post-pandemic costs. Both should work themselves out, but it will take patience.
Bottom line: The CPI is noisy right now. It makes sense to focus on PCE to better understand underlying inflationary pressures, which should matter to the Fed anyway.
As UBS’s Donovan points out:
The Fed currently appears to be caught in a trap. This has increased the importance of the CPI as a metric in mid-2022, although it traditionally favors the PCE. This makes it difficult to cut rates when the headline CPI is 3.5 percent.
The dispersion of price pressures in the PCE is now driven by a narrow part of the index (primarily housing and other supply-side inflation drivers). The gap between the increasing and decreasing elements of the index is now lower than its historical average.
Does this mean Powell’s midweek turnaround was a mistake? To answer this question, it is necessary to assess the overall direction of the PCE.
The producer price index reflects price pressures within the supply chain and is a good leading indicator of the prices that households end up facing. Annual PPI growth for final demand goods is now back in line with its historical range. Barring other supply chain issues or energy shocks, PCE products should perform well.
As for the labor market, Goldman Sachs compared several measures of tension. The average z-score – a statistical measure that relates a single data point to the average of a group of values – across all measures has essentially returned to pre-pandemic levels.
This suggests that wage pressures are likely to continue to ease. Indeed latest tracker shows that annual growth in posted wages has returned to 2019 levels. This means that the services component of the basic PCE should also be further relaxed.
Putting these elements together, the disinflation narrative seems alive and well for the PCE. Pressures in goods, services and housing (food and energy are now less of a problem) are easing, or already have.
But for completeness, there could also be political incentive for cuts, notes State Street Global Advisors, which is now seen as a maverick in still supporting rate cuts. Ideally, the Fed might want to make budget cuts before the U.S. election campaign really kicks off, given the outlook.
The asset manager also cites cracks in U.S. growth despite overall resilience on the surface – something Alphaville and Free Lunch have also highlighted recently – such as rising debt delinquencies, rapidly falling hiring expectations for SMEs and the fact that the average perceived probability of losing one’s job in the next 12 months is now higher than pre-pandemic levels, according to the New York Fed survey. ..
In summary:
— The recent revision of market prices is based partly on the reality of the data, but also on impatience, overemphasis on the headline CPI, and panic.
-The disinflation narrative remains alive and well. Current rigidity depends on idiosyncratic factors, including measurement differences.
-The Fed’s focus on data dependence has tied its hands. It’s hard to ignore the string of triple-digits that beat expectations, despite the details, forward momentum, and PCE all looking benign.
-Given the restrictive nature of real rates, pockets of economic weakness and the underlying inflation situation – excluding all noise – the Fed will likely have to cut rates further.
Still, given Powell’s midweek comments, the Fed appears more likely to cut rates later, and potentially to a lesser extent this year.