Has US Inflation Bottomed Out? Is It Heading Higher From Here? What Is Next?
We had the all-important US inflation data this week and just like last month there was a little something for everyone in the report.
For the inflation bulls: inflation went up for the second straight month and, coming in at 0.6% for the month was far more than expected.
For the inflation bears, core inflation moderated for the 3rd month in a row and is now at an annualized 2.4%.
It means inflation is now at an annualized 3.7%. That isn't a huge leap from June's 3.0% but it has firmly broken the downward trend.
This can be most easily seen graphically:
The dotted line is US inflation. The different colored bars are different components of the index analyzed on a year-by-year basis.
As you clearly see, there are certain components - especially shelter or housing - that are proving very stubborn and others - such as energy - that were in deflation but are coming back strong.
The overall picture of rising inflation once again could be just a temporary blip and prove to be transitory (haha) but it is inarguable that inflation is heading in the wrong direction right now.
The obvious conclusion is to pay close attention to the cost of oil and gas and keep an open mind that inflation could return. Rather than do this most people seem to be in one of two camps summarized as: "this is a nothing" or "this is everything."
The nice thing with this rather tiresome debate is:
Regardless of which camp you are in, it is going to be resolved soon.
Either inflation will continue to soften this autumn or it will begin reaccelerating and by Christmas we will look back at June's 3.0% as the low water mark in the struggle to defeat inflation, at least for now.
More annoyingly until it is fully resolved this tension will stoke some VERY politicized debates about whether this inflation is "real" or not.
2024 is an election year and we live in a hyper partisan and also politicized age. It will be very, very difficult for supposedly objective sources of wisdom and analysis to stay clear and sober in their analysis.
We are already dreading this development here at Pebble HQ. We also worry about it a lot.
One of the most notable and also concerning aspects of the 2021 transitory debate was just how many very prestigious economists through caution and humility aside as they argued for their political viewpoint AND have never truly been held to account for justifying a disastrous set of policies and positions. The high inflation of 2021 and 2022 didn't just happen by magic, t was intellectually supported for reasons of political expediency by far too many "experts" who should have known better.
We shouldn't be surprised - academia is not known for its humility or its accountability - but it was disappointing nonetheless.
Where do we fall in all this?
We think that the energy story and the rising price of gasoline and the like is a real problem. As we wrote last week, we didn't understand why people were not more optimistic on energy prices for much of the summer. Today we are struck by the fact that financial markets are apparently taking $90-a-barrel dollar oil and $4-5-a-gallon gasoline in stride, at least so far.
That may be about to change but, once again, the situation makes us pretty uncomfortable. Either we are right and the situation will worsen or we are wrong and we risk looking both foolish and being poorly set up from an investment standpoint.
But the real unpleasantness stems from our conviction that inflation will rise from here this autumn.
Practically speaking, we do not think anything will change for the Federal Reserve next week:
There will be no interest rate increase, for one thing.
And we suspect the US central bank's governors will try to play down the negative aspects of the report and play up the positive elements we outlined above.
It is pretty simple: they hope that given some time, energy will come down and we will be wrong.
They might be right!
But we are far more concerned because of that very wait-and-see approach. Just like 2021, we now risk letting the inflation horse out of the barn.
Lastly, there is the question of lower rates in the new year. Right now the US futures market think there will be 100 basis points (or a full 1%) of interest rate cuts in early 2024. That always seemed doubtful to us and seems doubly so now.
Where does this leave us?
The real tension point seems to be between shelter inflation on the one hand and energy on the other. Shelter inflation or the cost of housing always lags because, as anyone who has ever rented knows, it takes a whole year before you can either ask for lower rent and/or move to a new and cheaper home.
As we have written about before, shelter inflation is a large portion of CPI (over a third) and while it is coming down, it is only doing so only stubbornly.
You can see here from the always excellent Charlie Bilello:
The good news is, as the chart demonstrates, US rents are down significantly and this should hopefully feed through to lower shelter soon.
Alternatively, however, you have gasoline and energy rising quickly. It is all fine to say that these prices are volatile and could also come down quickly but that isn't guaranteed. And even if they eventually do, this doesn't put Humpty Dumpty back together again for those spending a significantly greater portion of their income at the pump right now.
And that is the rub really.
Will the cost of shelter continue to come down and do so quickly enough to counteract the impact of rising energy?
More prosaically, where the cost of energy ends up will determine whether inflation heads down to between 2 and 3% in 2024 or whether it stays stubbornly between 3 and, say, 5% in the coming 6 months.
We think it will very clearly be in the latter range.
As a reminder, we have previously argued two seemingly contradicting things:
The first is that it is going to be very hard to get inflation back down to the 2% target that is legally mandated as a goal for the Federal Reserve.
The second is that Federal Reserve may not care.
Now they won't say that of course. That would destroy their credibility. In fact they will "jaw-jaw" a lot and promise to bring down inflation no matter what it takes but we aren't sure they are willing to take the necessary actions.
Those actions would involve raising interest rates and possibly severely hurting the US economic expansion. As we slowly grind towards a VERY high stakes election year in the US, protecting that economy and avoiding any blame will be a high priority for the Federal Reserve in a politically tense and polarized age.
So, our argument is that the US central bank will "look through" a period of higher than target inflation and essentially hope that with some patience, some prayer and some persuasion, the economy, unlike Humpty Dumpty, won't stumble and fall.
In practical terms you should be conscious that this will likely mean that:
Inflation will stay higher than the Fed's target and higher than expected in late 2023 and 2024.
Barring a truly large leap in inflationary expectations, the Federal Reserve may hike 1 or 2 more times but that will be it and even then, they will be reluctant to do so.
Be ready for this other shoe to drop at some point. As we discovered in 2022 certain sectors and assets do very well in inflationary times. Others do not.
Is your portfolio set up for a return of greater inflation in the months ahead?
Forewarned is forearmed!
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