When Is Inflation Going Away?

This week, the Bureau of Labor Statistics (BLS) released the Consumer Price Index (CPI) for March 2024. It was only slightly higher than analysts had been expecting, 0.4% for the month, but you would have thought the sky had fallen. In some ways, I suppose it had.

At the start of 2024, many investors thought the Federal Reserve (Fed) had as many as 6-7 rate cuts up its sleeve for this year. If they were all of the 25 basis point variety (0.25%), that would have been a pretty significant reduction in the price of money over a relatively short time frame. Since cheaper money tends to goose economic activity in the short-term, the hope was that corporate America would be able to increase its earnings at an increasing rate.

As you can intuit, higher profits ordinarily lead to higher stock prices. It isn’t that difficult.

Unfortunately, recent economic data has put the Fed behind a proverbial 8-ball. Questions arise on how the Fed can cut interest rates, given:

• The economy created 303K payroll jobs in March.
• The official Unemployment Rate is 3.8%.
• The 12-month CPI is at 3.5%.

What’s more, given the method the BLS uses to calculate the CPI, there is little chance the 12-month number will improve significantly by the end of the year.

Unless, of course, the BLS simply lies about the data.

However, consumers are smarter than the government gives them credit for being. They know prices at the grocery, the pump, the insurance company and pretty much everywhere else are continuing to climb. To be sure, they might not be rising as fast as they were at the start of 2023 and all of 2022. But that doesn’t provide much solace when you are trying to make ends meet. Does it?

So, with persnickety inflation still rearing its ugly head, when does the Fed start cutting the overnight rate? Or will it?

If we are to believe the comments from Fed officials, the Fed would like to cut rates at some point this year.

1. This suggests it can’t envision continued economic expansion, at least at any meaningful level, to continue indefinitely.
2. It also knows there is a mountain of debt, at puny rates, which is going to reset at a much higher level in the not so distant future.
3. It further knows bank credit is going to be harder to get the longer lending institutions must “pay up” for deposits.

The Fed’s list of concerns is lengthy or should be.

Inflation just won’t behave. But why? Particularly after the Fed has been as aggressive in trying to tackle it as at any point in the last four decades? Is something different this time around? Hey, don’t get me wrong. This isn’t necessarily Carter Administration-era inflation. It isn’t. However, that doesn’t mean it doesn’t hurt.

So, how much longer will we have to wait for inflation to come down in a meaningful way? Better yet, how much longer until a trip to the grocery store doesn’t feel like it requires taking out a second mortgage?

The quick answer is don’t hold your breath. If you do, you will turn blue in the face and pass out on the floor. I wish I could be more sanguine about it, but there are some pretty large forces at play here.

1. First, due to globalization, the U.S. economy no longer controls its own supply chain the way it once did. Further, there are fewer domestic suppliers for a lot of key components. This means U.S. producers, arguably, can’t contain their cost structures the way they were once able. You can think of it in the way Southwest Airlines or Walmart enter a market. They keep prices low, perhaps artificially, to squeeze out the local competition. After that happens, they are better able to set the prices they want.
2. Second, although recent rains have lessened it somewhat, the persistent drought in the Midwest has had a massive impact on grain prices. As a result, cattle producers were forced to slaughter far more heifers in 2022 and 2023 than normal. Obviously, this reduced the number of new calves, which has put a ceiling on the amount of animals farmers can, um, process. Trust me, poultry producers don’t like the higher cost of animal feed either. As a result, many types of proteins will remain higher for longer. Interestingly, sometimes, the weather forecast is the most important economic news there is.
3. Third, the CPI doesn’t do a very good job tracking borrowing costs. This is tremendously important. Think about it. Imagine you want to finance a new car, or any large ticket item, and intend to take out a 5-year note. Even if the price of the car doesn’t change a penny, what happens to your monthly note when the interest rate goes from 4% to 8%? I will give you a hint. It doesn’t go down. However, the CPI only tracks the price of the vehicle, NOT the consumer’s actual monthly cost.
4. Fourth, although energy prices have come down from their peak levels in 2022, they still remain higher than the historical average. This puts upwards pressure on just about everything, from hard inputs to distribution costs to operating facilities to air-conditioning the CEO’s office. Someone will have to eat these costs. Unfortunately, there is little reason to believe energy will come down meaningfully in the next several years absent a severe shock to the global economy. More on that at a later date.
5. Fifth, while the money has come down almost $1 trillion since its April 2022 peak, there is still a lot of cash sloshing about the U.S. economy. Consider this, at the end of 2019, the Fed reported the M2 money supply index was $15.314 trillion. This past February, it was $20.784 trillion, which is, obviously, over $5 trillion higher. It has to go somewhere.
6. Sixth, average hourly earnings have accelerated so fast that the historical trend line since the worst of the pandemic. Put another way, employers are paying more for labor. Intuitively, the more they pay their workers, the more revenue they must generate to realize the same amount of profit. As a result, workers’ wages are putting an upward bias on inflation.
7. Seventh, and the last as this is getting lengthy here today, the U.S. economy simply isn’t as efficient as it once was. From the end of the 2^nd quarter of 2020 through the end of 2023, ‘average hourly earnings’ grew 16.88%, or 4.55% when annualized. By comparison, ‘U.S. labor productivity output per hour nonfarm business sector’ averaged 0.63% over that same time frame (quarterly SAAR observations). Not surprisingly, unit labor costs have mostly run substantially higher since then, especially since the end of the 3^rd quarter of 2020.

Is all of this the Fed’s fault? No, but it is its problem. As a result, it is hard to imagine, again, the Fed being as aggressive in cutting the overnight rate as people thought at the beginning of the year. In fact, the question which is still just a whisper in my ear is: “will the Fed cut rates this year?”

The fact it is even a whisper is the reason why investors responded so strongly to an otherwise pretty mundane CPI report on Wednesday.

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 any 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.