2023 Theme: US Inflation Falls, What Does It Mean & What Next?
On Wednesday of this week, the most important number for the global economy came out and was quickly digested and hotly debated by investors, algorithms and economic actors everywhere.
It has been a few months since we have written directly on the inflation print so we thought we would return to the subject and provide both an update and, perhaps more importantly, frame what to watch for from US inflation as we look forward to the rest of the year.
The basics:
The number came in at 4.9% on an annualized basis. That was less than the 5.0% predicted and obviously had a nice psychological angle as well beginning with a "4" for the first time in over 2 years.
Month-over-month inflation was 0.4%.
Last June inflation crested at 9.1% and markets hit a low for the year shortly thereafter. Today, over 40% of the CPI basket (by weight) is in outright deflation.
All in all, this is great news.
Here is the annualized chart, which can be a bit misleading but the blue is inflation and the orange is "core" inflation which is minus the more volatile (though important!) food and energy and also declined to 5.5%.
The takeaways:
The good: inflation cooled for the 10th straight month. Pretty good! The trend continues and , as we cover below, there are good reasons to expect this to continue. Yay.
The less good: Inflation is still pretty high. A 4 "handle" on inflation is big news and a welcome development but 4%+ is still over double the Federal Reserve's mandate and the risk is that it is now entrenched.
Why?: The primary drivers of this were not that big a surprise - though they were slightly better than a lot of analysts expected: food and energy costs have come down a lot.
What now?: The question is, of course, will services now follow the collapse in goods prices?
A lot hangs on that question.
Here is the breakdown by different sectors to the CPI basket. As you can see services are the final bastion of rising prices.
The expectation is they will fall but the question is whether higher service prices starts feeding back to higher goods etc.
Add it all up and practically speaking:
It seems likely that the Federal Reserve will pause hiking interest rates in June and perhaps longer. The combination of the bank stress, the declining trend in inflation and the expectation that it will continue should be enough to at least make
In other words, some of the stuff that is still high are expected to either be a one off (like used cars) or to typically lag and so expected to come down in the future (like rents and cost of shelter).
Furthermore, the Federal Reserve suddenly has other priorities to consider.
Why?
Well, the Fed has a dual mandate. Its remit is to care about unemployment and financial stability as well. With US banks failing and inflation trending in the right direction, the central bank's job naturally becomes more balanced. It also becomes harder.
The flip side of this for investors is their task also gets more difficult. A lot of the focus this week is on the lower number and understandably so. However, going forward, predicting what the US central bank will do is going to get far harder.
Will they be focused on inflation or unemployment is going to be a constant debate now that both parts of the mandate will be in play.
The risk to all this talk of "the Fed is done" is clearly that:
As we have seen quite frequently, the US economy is proving to be very resilient and that is both wonderful but also means that, well, the economy will keep growing which, at its most basic, will support inflation.
It is simply very difficult to believe that inflation can fall to a very low level with the economy growing as it currently is. We are not alone in saying so either. Larry Summers, Mohammed El-Erian and plenty of big bank macroeconomists have made the same point over the last year:
There is a real downside of economic resilience.
This is uncomfortable but doesn't make it wrong. We might have a pause of interest rates in June but eventually if the economy continues to grow then interest rates will follow them just like the May flowers after April showers.....
For now, just keep in mind that the pause in interest rates in June - if we indeed get one! - may be a momentary pause.
If we were pushed, as we have stated before, that is our bias: higher rates are here to stay.
We may be wrong on this. As recently as two weeks ago the market was expecting interest rate CUTS to begin this June and it is not as if there are not risks to the economy. We are potentially playing a game of political chicken with what remains of the reputation and smooth functioning of the credit system.
So be very careful.
But we feel confident that interest rate cuts will not be happening immediately after a pause. History suggests as long as the labor market stays robust, cuts do not quickly follow a pause:
Lastly, one question we wish we would be asked a bit more regularly as part of all this something we have mentioned before:
We have hiked interest rates at the fastest rate ever and millions more Americans have gotten new jobs at the same time. The jobs market has strengthened during a time of costlier credit and tighter financial conditions.
That isn't just unexpected. That is a borderline stupendous and should be front and center in every policy discussion going forward. Being able to tighten the economy and raise the cost of credit while keeping regular Americans employed is an incredible masterstroke and should be celebrated as such.
We have criticized policymakers plenty in this newsletter but we should also acknowledge that, so far at least, they have engineered the infamous "soft landing" of so many press conferences and monetary policy legend.
The only problem is that we have not yet really landed the plane. 4%+ inflation is not 2% even in today's post truth age.
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