Last week, we received several economic data points, with the Consumer Price Index (CPI) perhaps being the most important as a measure of inflation. On a year-over-year basis, the inflation rate was 3.24% with a core rate (less food and energy) of 4.03%. While the Federal Reserve prefers to use the Personal Consumption Expenditures (PCE) Price Index as its inflation metric, Dr. David Kelly of J.P. Morgan notes that the Federal Reserve’s PCE target of 2% equates to about a 2.5% inflation rate on the core CPI scale.
As the chart indicates, we are still some distance from the 2.5% core CPI reading.
Focusing on the core CPI, let’s take a closer look at the monthly and year-over-year charts.
Without getting into the math, at a month-over-month core CPI inflation rate of 0.23%, and provided the rate holds steady, in a year’s time we would arrive at a core CPE rate of 2.8%. Looking again at the chart above, the lower month-over-month rates in June, July, and August boded well for inflation, but the sudden uptick in core inflation in September and October was a cause for some concern. It’s little wonder, then, that the Fed has been making the case for a higher-for-longer scenario; they’re afraid of declaring victory too soon.
Why the Fed Is Being Cautious
A closer look at the components of inflation gives us some insight into the Fed’s caution.
The current slowdown in inflation is centered on disinflation (not to be confused with deflation, where prices actually drop) for non-durables and actual deflation in durables. However, services and housing continue to be strong. Almost certainly the Fed will want to see a more broadly based slowdown in inflation to be satisfied.
We also received a reading on the Producer Price Index (PPI), which declined 0.46% for the month and was only 1.34% year over year.
Persistent deflation can have a distorting effect, however, as buyers expect future prices to fall, so they wait for the next price cut. This incentivizes further price cuts, which, in turn, affect workers’ pay and profits and can result in a vicious cycle.
In addition to these inflation indicators, retail sales figures show a month-over-month decline of 0.11%, which brought the year-over-year growth rate down to 2.48%.
The slowdown in retail sales was concentrated in more volatile areas, such as automobiles and furniture, while more core retail sales showed month-over-month growth.
Figures on real (adjusted for inflation) hourly earnings, meanwhile, showed an uptick in both month-over-month and year-over year-readings. And while it is good to see the month-over-month readings returning to positive territory, it is easy to see how consumers continue to feel they are just treading water despite the recent declines in inflation.
Weakness continued in manufacturing, with industrial production being negative for both month-over month and year-over-year readings, meaning that capacity utilization is also declining. The relative weakness in manufacturing is likely to result in declines in capital expansion.
With the relative weakness in existing home sales, the markets continue to look to new housing to help take up the slack. Housing starts rose to 1.4MM units.
Overall, some in the press continue to make the case for a soft landing, with economic growth continuing and inflation declining, though this is by no means guaranteed. Inflation can be persistent, so it’s reasonable to expect it may take close to a year for inflation to approach desired levels. Moreover, at the current level of inflation-adjusted income, many households are only able to grow their wealth very slowly. For these reasons, we continue to believe we are headed toward a recession, or even stagflation, which is characterized by slow growth combined with higher inflation.
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