This week, the markets had to digest two disappointing economic reports. Objectively, they did so splendidly. To that end, the S&P 500 was up over 1.5% during the week as of 2:00 pm CDT.
The first piece of bad news came on Wednesday. The Consumer Price Index (CPI) for January 2025 was higher than expected. In aggregate, prices increased 0.5% during the month which caused the trailing 12-month number to increase from 2.9% in December to 3.0%.
Let’s just say that is the wrong direction and not what anyone wanted to see. If nothing else, it likely puts off the next Fed rate cut by another 2-3 months, at least.
Then, this morning, the Census Bureau (Census) reported retail spending fell a sharp 0.9% last month. To be sure, you would expect a decrease after the holding shopping season. However, the 0.9% decrease accounts for so-called “seasonal factors.” The actual decline was significantly more in absolute, non-seasonally adjusted, terms.
Basically, in both absolute and relative terms, the U.S. consumer took a little bit of a breather in January.
This presents us with an interesting situation. If we are to believe/trust the data, consumer demand went down in January and prices went up. Hmm. That isn’t exactly what I learned in business school, but okay. Pretty neat trick, really. But one month does not necessarily a trend make.
I suppose you can throw these two reports on the same pile as last week’s bizarre “Employment Situation – January 2025.” They might not make a lot of sense, but we have to live with them.
But what does it all mean? Just how strong is the economy? What is the Federal Reserve going to do next?
After analyzing the CPI report, I came to a counterintuitive argument in my mind. What if higher interest rates are causing inflation, as opposed to driving down prices? Now, hear me out.
The conventional wisdom is that higher rates reduce the demand for money. Put another way, borrowing and lending slows down.
- This reduces the growth rate in the money supply.
- When this happens, people consume less and tend to be more price sensitive.
- As a result, overall economic activity cools as companies decrease supply to meet the decrease in demand.
Now, if all goods and services were elastic (highly sensitive to price changes), the above points would be sacrosanct. No argument. That is simply the way it would work 100% of the time.
But what about inelastic goods and services? You know, those things which you have to buy, as opposed to want to buy, which aren’t sensitive to changes in price. What do higher interest rates do the price of those items? Huh.
Food is the perfect example of an inelastic product. We can’t live without sustenance. Period. So, we will spend whatever we must up until our very last currency unit. Fair enough.
Not surprisingly, a lot of the food on our tables comes from massive commercial farms/companies. Jefferson’s idyll of a nation of honest yeoman farmers tilling the soil was a dream in his day and a fantasy in ours. Food is a business, and businesses usually borrow money.
When interest rates go up, so does the/a company’s debt service. Ordinarily, this means they have to either:
- sell more product
- increase the prices of their products
- reduce expenses elsewhere
- any combination of the first three
In an ideal world with unlimited competition, companies can’t blithely raise their prices to offset an increase in their costs. Other firms would undoubtedly undercut them to gain market share. Unfortunately, over time, the big guys have gotten bigger and the small guys have gone out of business, one way or the other.
For instance, in the United States, four companies, know as the Big 4 Beef Packers, control upwards of 80% of the meatpacking industry. They are: JBS, Tyson Foods, Cargill and National Beef. Let’s just say there isn’t a lot of competition.
With this in mind, imagine this little scenario.
Cattle rancher X has a herd of 1,000 head. Ordinarily, they would sell, say, 200 head per year. However, drought has caused a spike in feed prices AND higher rates have increased the amount of interest they owe the bank. Furthermore, the Big 4 is paying less than they were because their debt service has also gone up.
Therefore, to make the same amount of money OR lose less, the rancher decides to sell 300 head this year, half of them heifers. No sweat in Year 1. However, what about year 2 or 3, possibly even 4?
Since it takes 18-24 months for a cow to reach a market weight, the rancher finds themselves struggling to keep up. Those additional 150 heifers they sold weren’t around to reproduce, so the herd is growing at a decreasing rate…at best. As a result, the supply of cattle available to the end consumer is reduced.
Finally, beef seems to be almost an inelastic good in the U.S. economy. As a result, the rancher now has a shred of pricing power due to the decrease in supply, as in able to pass along some of their increased costs on to the Big 4, not much mind you. In turn, the Big 4 can jack up what it charges for processed beef since Americans will apparently continue to buy it, regardless of price.
In this example, higher interest rates are part of the problem with inflation on/for inelastic goods and services. The producer will simply pass along the increase in their debt service to the end consumer, at least as much as they can. In a fully competitive industry, with many players, this is relatively difficult.
As the number of players decrease, the ability to do so increases, especially if the competitors are spread out by geography or distribution networks.
Does this make sense? Essentially, in a consolidated industry producing inelastic goods, companies might be better able to pass along their increased costs to consumers. This isn’t a certainty, but the potential is there.
If you can accept this line of reasoning, you might then be willing to accept the following end logic:
“The higher the cost of borrowing—specifically, rising interest rates—puts greater upward pressure on prices for inelastic products, especially in industries with limited competition.”
Nerdy stuff, to be sure. Further, it could be complete rot. However, something strange is going on in the economic data and the markets which rely on it. As such, thinking outside of the box is going to be imperative to produce results moving forward.
Have a great weekend.
Thank you for your continued support. As always, I hope this newsletter finds you and your family well. May your blessings outweigh your sorrows on this and every day. Also, please be sure to tune into our podcast, Trading Perspectives, which is available on every platform.
John Norris
Chief Economist
Please note, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as well as those of our Investment Committee, is subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the rest of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself.