One More for the Road

As we enter July, with Jay Powell singing a hawkish tune, we expect the market to be very focused on one question: Are interest rates going higher? The answer lies in the inflation data yet to be reported. If inflation fails to get better, then interest rates are likely heading higher. If the current downward inflation trend continues, then there is cause for optimism that rates have peaked and we could be on the road to recovery.

The recent CPI inflation news has not been great, but it has been good enough to define a clear downward path. We are still a ways away from the targeted 2% level, but we are headed in the right direction. If it all comes down to inflation, let’s take a good look at what needs to happen to keep this trend on track.

One of the factors making the inflation numbers look good has been the fact that inflation was very high a year ago, which makes comparisons relatively easy. This is known as the ‘base effect’. The challenge this summer is that the base effect is beginning to make inflation comparisons more difficult.

Rather than debate where inflation is going, we prefer to look at what needs to happen to keep the downward momentum going. The Federal Reserves’ favorite measure of inflation is Core PCE Inflation (Personal Consumption Expenditures). Core simply means that the data excludes the very volatile food and energy categories and is therefore considered a better barometer of underlying inflation trends.

The chart below shows the month-over-month (MoM) change in Core PCE Inflation. The blue line is the actual data and is obviously a bit choppy. The orange line is a 3-month moving average, which smooths the data. Note that leading up to the pandemic, Core PCE inflation was running between 0% and 0.2% per month, and while it seems odd now, the Fed was actually trying to increase inflation a bit because it was running below their target. All that changed in the aftermath of the pandemic and beginning in Spring 2021, core inflation was running around 0.4% per month, or about 5% annually. May data, which was released Friday morning, showed MoM Core PCE inflation running at 0.31%, which encouraged the stock market. But looking at the data, that level is not much different than it has been the last several months. Despite the decline in headline inflation, core inflation simply hasn’t changed much, and that is what is particularly concerning to the Fed and is the most likely reason that they are currently projecting more rate increases later this year.

However, there are also things that make them think twice about those projected increases. The largest of these is the real estate market. Inflation data picks up changes in rent and real estate prices with a significant lag. Real time data suggests that rents and prices are beginning to wane, but that has not yet appeared in the inflation data. As a result, there is some hope that this measure of core inflation will also begin to recede as that data is included. The Fed’s conundrum is that they can’t accurately anticipate how this will affect core inflation data in the months to come.

Of course, there are other moving parts to this equation as well. For example, there is also some evidence that selected goods prices, which had been receding, may be beginning to turn up once again.

The second chart shows the year-over-year (YoY) change in Core PCE inflation (dark blue line). The colored lines are how this chart would look through March of 2024, if the trend from here is 0.1%, 0.2%, 0.3% and 0.4% per month. The message here is quite simple. If Core PCE inflation is to approach the 2% target by Spring 2024, Core PCE inflation needs to quickly be reduced from current levels. If core inflation persists at 0.3% per month, YoY core inflation will still be running at about 3.75% in spring 2024. The stock market clearly liked Friday’s PCE data, but it has to get better quickly to avoid more rate hikes.

This is where the Fed earns its money. Making the early calls for rate increases were ‘no-brainers’. Anyone could have made those calls. However, now we are at a sensitive point. The big increases have already compounded problems in commercial real estate and caused problems in the banking sector. Now the situation requires a more nuanced approach and the Fed needs to pull the right levers to make this work.

How will we know if it’s working? Watch core PCE inflation (released near the end of each month). If Core PCE can be reduced from the current reading of roughly 0.3% MoM to 0.2% from June 2023 through March 2024, that would bring the annual inflation rate down to about 2.75%. That is still above the Fed’s 2% target, but certainly within shouting distance. Any reading at 0.2% or lower, is moving us in the right direction. Above 0.2%, only means it is a longer trip to get back to the 2% inflation target and that raises concern of more rate increases. The Fed may still give us one more, or even two more, for the road.

Why is this important? Because recessions don’t just happen, they are typically initiated by the Fed. They have been trying to thread a needle for a few years now, and the next  several months will probably determine if they succeed and avoid recession or if they push us over the edge again.

“One more job oughta get it
One last shot, then we quit it
One more for the road”

Boz Scaggs/David Paich; Lido Shuffle

What We’re Reading

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Most investors believe we are in a new bull market

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Netherlands, home to a critical chip firm, follows U.S. with export curbs on semiconductor tools

Biden’s student loan defeat adds to headwinds for US economy


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By: Adam