This week, the Federal Reserve didn’t raise the target overnight lending rate. The industry has called this a pause in the tightening cycle, as it expects one more rate hike before the Fed calls it quits. Also this week, the Bureau of Labor Statistics (BLS) announced the headline Consumer Price Index (CPI) rose a paltry 0.1% during May 2023. As a result, the trailing 12-month CPI nosedived from 4.9% in April to 4.0% last month.
Surely, we can finally proclaim inflation is dead! Right?
As I type, I would argue declaring the war against inflation over analogous to saying the American Civil War was over after the Battle of Gettysburg. Directionally, you would be right, but there is still a lot of fighting remaining. So much so, anything could still happen, as could have back then.
But why am I so negative after a week of largely good news on the inflation front?
The answer is simple. When consumers hear the phrase “inflation is coming down,” they interpret that to mean prices are falling. Unfortunately, all that phrase means is the rate of price increases is increasing at a decrease pace.
What is the old expression? Prices go up using the elevator, but come down using the stairs? While somewhat amusing, you could sensibly argue they come down using the stairs on all fours.
On Tuesday, after the CPI announcement but prior to the Fed, I made a presentation to a group of business professionals here in Birmingham. Obviously, inflation was a topic of discussion, and used the following example to explain why prices won’t be in a hurry to come down.
Imagine a producer sells its widgets for $5/unit. Its current COGS (cost of goods sold) is $3/unit. At what price will it sell its widgets IF its COGS were to fall to $2 or $1/unit? Think about it. What was your answer? $3, $4 or $5?
The probable case scenario is the company will continue to sell its widgets for $5 as long as the market is willing to pay it. Why would it not? After all, it would make a higher profit in so doing.
This makes sense at the individual company level, doesn’t it? So, why wouldn’t it at a macroeconomic level? After all, the economy is little more than an amalgam of businesses and consumers all trying to find the best products/services at the best possible price.
Essentially, if the market clearing price for widgets is $5, there is no reason for the company to sell for less. That is unless it is run by fools or perhaps a state-owned entity for which profit isn’t a concern.
Basically, if this week’s headlines had you dreaming of a smaller grocery bill or a break on your utilities, you might have to wait a little while longer yet. To be sure, the deals are a little better at the Publix, Kroger, Albertson’s, Wegman’s or Winn-Dixie than they were last year. However, outside of specials and BOGOs, and who doesn’t love a good BOGO, stated prices don’t appear to have fallen with the possible exception of eggs and Bud Light.
At least not where I shop.
Your experience might be different than mine, and I hope it is. However, I also have a mountain of official data which would suggest you might be the exception than the rule. After all, I breakdown each CPI and Employment Situation report with the best of them.
In truth, this past month’s CPI was all about declining energy prices. Since I am not sure if I filled my tank even 2 times during May, you might excuse me for not noticing. This can happen when you get 25/36 mpg, and live 4.1 miles from the office.
Even so, the official ‘energy’ sector of the CPI number had a 6.978% weighting in April 2023. According to the BLS, it fell 3.6% during May. With these two numbers, I calculated energy’s impact on the overall equation in a couple of different ways. Both estimated this sector alone shaved roughly 0.3% off the total.
Essentially, but for the relatively volatile energy sector, the rest of the equation was 0.4%, which works out to be 4.91% when you annualize it. Not surprisingly, while the headline 12-month CPI number fell to 4.0%, the so-called ‘core’ number (ex. food & energy) dipped ever so slightly from 5.5% in April to 5.3% in May.
In other words, inflation is far from dead. It just depends on where you want to look for it. To that end, I would be more willing to put a small wager on energy prices either staying flat OR increasing over the next 12 months. They certainly won’t be falling 3.6% per month, and if they are, whew, bad stuff is happening elsewhere.
For better or for worse, the investment markets have also figured this out.
On March 16, 2023, obviously 3-months ago, the Fed Funds futures market believed the highest implied overnight rate would get to 4.925% in May. After that, the Street thought the Fed would be cutting rates pretty significantly. So much so, at that time, the implied policy rate out in January 2024 was 4.10%.
In so many words, investors believed in March the war on inflation would be over.
As of this morning, the same futures market believes the implied overnight rate will top out at 5.30%. It is currently 5.07%. Obviously, this would suggest an additional 25 basis point (0.25%) increase. What’s more, that implied rate for January 2024 is now, drum roll please, 5.11%.
Obviously, those 4 rate cuts which the Street thought would happen in March are out the window. They wouldn’t be IF inflation the war on inflation were over. As such, there is still a lot of fighting left to do.
In the end, the news on inflation was better than it has been in some time. The Fed did what everyone thought it was going to do, nothing. And, ultimately, many people didn’t see the improvement in their monthly budgets the headlines screamed they should be seeing.
Such is life when inflation is supposed to be dead.
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 any every day. Also, please be sure to tune into our podcast, Trading Perspectives, which is available on every platform.