Was March CPI a Nothingburger?

This week we learned that consumer prices rose at a higher-than-expected rate for the fourth month in a row in March. It’s been widely reported that one of the sources of upside pressure on prices has been housing costs, which continue to outpace the overall CPI index whether you’re a renter or a prospective owner. With regard to rents, though, we know that the growth should slow going forward because the methodology used to track rents includes all outstanding leases rather than only newly signed leases. We also know that housing prices, which aren’t explicitly included in CPI but are instead accounted for by estimates of “the implicit rent that owner occupants would have to pay if they were renting their homes,” are actually inflated right now due, in part, to the sharp increase in interest rates. The rationale here is that the supply of houses for sale is artificially suppressed right now because homeowners are reluctant to give up a very valuable asset – their low-rate mortgages. Suffice it to say, then, that the Fed is probably not deferring interest-rate cuts due to the growth in shelter costs. If anything, the opposite could (or at least should) be true.  

That brings us to non-shelter services, which the Fed tracks closely in the formulation of policy. One metric used to track services pricing is the Super Core CPI, which includes all services except energy and housing. These prices are represented by the green line in the chart below. You can see that the line has been moving upward over the past few months and is now significantly above both the headline CPI and core CPI, which excludes food and energy. Economists believe that inflation rates within the Super Core categories, which represent a little over one-quarter of the total CPI, are particularly troublesome because they are influenced by wage growth. Wage growth has been running at over 4%, and many economists believe that ongoing labor shortages will perpetuate those outsized wage gains. If so, services prices may not relent anytime soon.

But if we dig a little bit deeper into what’s driving the inflation in the Super Core categories, we find that one category is most to blame, by far. Prices for motor vehicle insurance, which comprise a little less than 3% of total CPI but a much higher 11% of Super Core CPI, were up 22.2% year-over-year and 2.6% sequentially in March. Applying some basic mathematics reveals that roughly half of the year-over-year and sequential increases in the Super Core CPI were driven by these huge price increases for auto insurance. The sharp rate increases are the result of several factors, including the rapid growth in new and used car prices over the past few years, parts shortages, labor shortages, natural disasters and other factors. The most important factor, however, is likely the fact that the replacement cost for vehicles lost in accidents has gone up a lot. As such, the increase in auto insurance rates should be considered a lagging inflation indicator, reflecting past increases in car prices rather than current and future increases in the cost of providing auto insurance. Will this lagging inflation indicator be enough to put the Fed on hold indefinitely?

The impact of the March CPI release over the past day has been fairly dramatic. The markets have gone from pricing in about 0.65% in Fed interest-rate cuts by year end on Tuesday to just 0.42% today. And as you can see in the chart below, expectations for rate cuts had already declined by a huge amount since February 1. Will these declines prove justified? It’s hard to say. Inflation rates could prove sticky if, for example, energy prices continue their recent climb and/or asset prices (stocks, residential real estate) keep going relentlessly higher. Inflation could also stay elevated if the federal government keeps running $2 trillion deficits. However, based on the March CPI data alone, it appears to me that the sharp selloff in the bond market could be a little premature. And for the moment, anyway, the sell-off in stocks following the CPI release was more a reflection of high valuations and some necessary consolidation after a long move relentlessly higher. It’s been a long time since we’ve seen a normal 10% correction in stocks (July/Aug 2023), and perhaps this March CPI report could serve as the catalyst. But if so, I don’t think we can blame auto insurance rates.

All this is to say that the March CPI report did not really change the investment backdrop, which can be summed up like this: The Fed took rates from 0 to 5.25% to bring inflation down. Until recently, this campaign appeared to be working very well. Inflation has come way down from the highs without the interest-rate increases causing a significant drag to the economy. However, inflation now appears to be settling in closer to 3% than the 2% that the Fed would like. As a consequence, the Fed is now on hold. At the beginning of year, the expectation was for six Fed rate cuts (0.25% each) this year. That expectation has now been reduced to between one and two. The stock market’s 25% gain since the end of October 2023 has largely been driven by the belief that the Fed tightening cycle was over and that multiple interest-rate cuts would be coming as inflation continued to ease. Investors are now revisiting those assumptions. 

I continue to believe that now is the time to be defensive with the market trading just a few percentage points below its all-time high. However, the basis for that defensive posture is not the March CPI report. I believe that the markets’ (especially the bond market’s) reaction to the report was probably overdone. My bigger concern continues to be the lagged impact of the spike in interest rates on an economy saddled with debt.