This morning I had a meeting at a coffee shop in Mountain Brook Village here in the Birmingham area. I have lived in this particular suburb for most of my life. As I was waiting, I looked at my surroundings. With a couple of exceptions, the view from where I was standing was the same as it was when I was a child. I suppose that is Mountain Brook’s appeal, and Birmingham’s for that matter — they don’t change very much.
Of course, you could make a reasonable argument that this is in fact a problem. To be fair, the new development where the old Western supermarket and Britling cafeteria once were is a massive improvement. However, for all intents and purposes, that is relatively recent, and change has come relatively slowly over the past five decades.
I am not waxing nostalgic about my childhood. No. It just seems the past 12 months have been a lot like the last, again, five decades in Mountain Brook Village. What is the old expression? The more things change, which they have, the more they stay the same? Indeed.
Twelve months ago today, the Russians invaded Ukraine. At the time, no one thought it would last very long. In fact, many so-called experts thought Kyiv would fall within a week or so. Such was the Kremlin’s reputation as a military power. However, war is war, and the world was worried it would spread.
Domestically, at the same time, investors were worried about disturbingly high inflation data and what the Federal Reserve’s response would be. Would it crush the economy, like Paul Volcker did in the early 1980s, to squash inflation? Or would it be more dovish, tightening the screws ever so slowly in the hopes things would calm down on their own?
As I type, the Russians and Ukrainians are still battling it out. Inflation is still a problem, and no one is completely sure just when the Fed is going to stop raising the overnight target night. In essence, the more things have changed over the last year, our primary concerns have stayed the same. Russia. Inflation. Federal Reserve.
Depending on to whom you speak, those worries might not be in order. Unlike the appealing nature of the Village in front of the Bromberg’s building, this lack of change in the world is equal parts troublesome and tiresome. In other words, it stinks.
This morning, the Bureau of Economic Analysis released the most recent Personal Consumption Expenditures Price Index (PCE). This is another relevant inflation gauge, which the Fed arguably considers more than the CPI. I will cut to the chase. It was higher than expected, and much higher than it was in December. The core deflator was higher than expected, as were all of the primary trailing 12-month observations.
After the disappointing CPI and PPI a couple of weeks ago, investors were hoping the PCE would show greater signs of prices abating. The reason for this is simple. Time. In 2022, inflation was hottest the first six months of the year. Since the trailing 12-month number is nothing more than a product of the monthly data, investors want to replace high numbers from 2022 with low numbers in 2023.
For instance, the PCE was 0.5% in January 2022. Last month, 2023, it was 0.6%. Obviously, this means we replaced a lower number with a higher number in the 12-month equation. As a result, it was higher this month than last. I hope this makes sense.
In February, we will have to replace a 0.6% reading from 2022 with something less than that for the unofficial, official inflation number to trend lower. Essentially, over the next five months, the monthly PCE has to been less, significantly less, than the following, in order, starting in February: 0.6%, 1.0%, 0.2%, 0.6% and 1.0%.
If there isn’t any meaningful improvement in the data, the Fed will have little choice but to keep raising the cost of money in the U.S. economy. Obviously, that would, could or should slow overall economic activity. That would run the risk of making a proverbial “soft landing” that much more difficult to achieve. In essence, a recession, of some severity, would become more likely.
There is that word again, recession. It seems we worried a lot about it last year, doesn’t it? So let me ask you, what has really changed? Other than the color of my hair. Much more of this angst, and the few hairs in my head with any remaining color will also turn white.
The biggest question mark is what is going to happen with housing. More specifically, what is going to happen with rental rates moving forward? After all, they make up a whopping 34.04% of the overall CPI equation. If they don’t improve meaningfully, neither will the overall equation. Literally, it is just the math.
So will they improve? That is a great question. Clearly, one would hope. However, when interest rates go up, buying a home becomes less affordable. To that end, the Homebuyer Affordability Fixed Income Mortgage Index has sunk like a stone since the Fed started raising rates. Intuitively, if buying is that much more expensive, the demand for rentals could, would or should go UP.
Historically, going back to 1983, there is a 0.31 positive correlation between the absolute value of the U.S. CPI Urban Consumers Rent of Shelter Index and the Fed Funds target overnight rate. While not outrageously strong, the two tend to move in the same direction. As such, the more the Fed raises the cost of money in the economy, the more unattractive buying a house could be.
If it seems like a self-fulfilling prophecy, if that is the right term, it sort of is. One can only hope all of the multifamily housing “we” have put up around the country over the past five-plus years will swamp that 0.31 positive correlation. I hope that makes sense.
In the end, we have about five months to make this happen, a meaningful decrease in inflation, or we will keep kicking the proverbial can down the road. We will still be worrying about the Federal Reserve. After all, that is what U.S. investors do. Further, the Russians will still be tormenting the Ukrainians. If you know your history, you know that is just what Russians do.
Again, the more things change, the more they stay the same. Whether it be the Kremlin, inflation, at the Federal Reserve or in Mountain Brook Village.
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 & Cynic
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 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.