Getting Closer!

Yesterday’s reading for the April Consumer Price Index (CPI) was greeted enthusiastically by the markets, and for good reason. The index increased at its lowest year-over-year rate since March 2021. The YOY growth rate has now dropped from a high of 9.1% in June of last year to just 4.9%. And while the rate is still well above the Fed’s target of 2%, we think there was enough in this report to convince the Fed that no further rate hikes are needed at this time. 

Chairman Powell and other Fed members have inferred that their lingering inflation concerns are confined to a specific set of consumer prices: core non-housing services. The Chairman made those sentiments explicit on February 2 following the Jan 31 – Feb 1 Fed meetings: “The issue is that we have a large sector called non-housing service—core non-housing services where we don’t see disinflation yet. But I would say that so far what we see is progress but without any weakening in labor market conditions.” The Chairman subsequently clarified his position by saying he doesn’t expect to see broader services disinflation until the labor market starts to loosen. And so the markets have effectively been in a holding pattern, waiting for more evidence of a turn in core services inflation. We may have received that evidence yesterday.   

First some background. The chart below shows the Consumer Price Index broken up into different components and using weightings as of March 2023. The slice that Powell & Company are worried about is gray. But first me explain why he isn’t worried about the other categories in the pie chart. The dark blue slice represents food & energy prices, which account for about 20% of the overall index. These prices are highly volatility based on a slew of supply-and-demand factors that are beyond the control of the Fed. So, even in normal times, the Fed tends to base policy on the CPI, excluding less food & energy prices. 

The next category, represented by the orange slice and comprising about 21% of CPI, is commodities less food & energy commodities. You can see from the chart below that price growth for this category has already dropped to the Fed’s target range. The progress has been driven mostly by the healing of COVID-related supply-chain bottlenecks and a shift in consumer spending from goods to services. 

Next up is housing-related costs, which are important because they represent nearly one-third of the overall index. The two big categories for housing costs within the CPI are “rent of primary residence” and “owner’s equivalent rent” or “OER.” OER represents “how much money a property owner would have to pay in rent to be equivalent to their cost of ownership” (Wikipedia). In the chart below you will see that those prices were up 8.8% and 8.1%, respectively, on a year-over-year basis in April. Those are the highest rates of growth we’ve seen in those categories for this cycle. If rents are rising at such a rapid pace, why isn’t the Fed concerned? The answer is the government data on housing costs lags actual rent changes, and all the evidence, both hard and anecdotal, suggests that housing costs are now coming down from their recent highs. The second chart below, which was taken from ApartmentList.com, is a better gauge of the cost of new rentals. According to the Apartment List web site: “While our index has shown that rent growth has been consistently cooling since early last year, the housing component of the official inflation estimates produced by the Bureau of Labor Statistics (the Consumer Price Index, or CPI) is just now appearing to reach its peak. This is because movements in market rents lead movements in average rents paid, meaning that our index can signal what is likely ahead for the housing component of CPI.” The Fed knows all this, and that is why there is very little concern about housing costs right now among the Fed’s membership. 

That brings me to the category that has been the subject of Fed angst. Core services less housing (also excludes energy services) currently represents about a quarter of the CPI. Prices for this category have been growing rapidly, driven by hefty wage increases and that shift in spending from goods to services that I mentioned above. However, there appeared to be a meaningful deceleration in April. Core services less housing rose just 0.11% in April compared to March. That rate was down from the 0.40% increase in March compared to February. On a year-over-year basis, core services excluding housings costs decelerated to 5.1% in April from 5.8% in March and a high of 6.5% in September of last year. The sequential deceleration was attributable to moderation in prices for some medical care and recreation services; transportation services (car & truck rentals and leases, vehicle maintenance, air fares); education and communications services (tuition & fees, childcare, internet services, etc); and some other miscellaneous services. The moderation in inflation for many of these categories will be most welcome by the Fed. The big question is: will it continue? Many Fed members will remain skeptical because of the continued strength in the labor market, which tends to drive services inflation. 

I haven’t been shy in voicing my opinion that it’s high time the Fed stops its rate hikes. My main concern is that there are a headwinds in the pipeline that will continue to weigh heavily on the economy and therefore prices. Among these headwinds are the following: 1) there is a delayed impact of 500 basis points of Fed rate hikes; 2) the regional bank crisis will likely exacerbate the trend toward tighter lending standards; 3) most consumers have exhausted the savings built up during the COVID years and are now living paycheck to paycheck; 4) the student loan payment moratorium will soon expire after 3 years; and 5) the risk that a debt ceiling increase won’t happen. These headwinds and more are likely to lead to a cooling in the labor market, which, as the final charts below show, has already begun.    

The following chart shows year-over-year growth in average hourly earnings. 

Fortunately, I think the Fed now has enough data to comfortably sit back and see what happens. I think the rhetoric going forward will reflect that change of heart. The next big question is whether or not the economy will deteriorate enough to cause the Fed to start cutting interest rates. The Fed continues to suggest this won’t happen anytime soon, but the bond market continues to disagree. Keep your seatbelts on.