Maybe it’s something about the dog days of summer — the record heat in the last few weeks has made everyone a little delirious — but the July-August period is proving particularly popular for “pivot” rallies in US financial markets. Last summer, of course, yields on two-year Treasury notes fell all the way to 2.82% before Federal Reserve Chair Jerome Powell upended gains with his infamously hawkish Jackson Hole speech. Right on schedule, the latest consumer price index on Wednesday seems to be lighting a fire under bond market bulls once again. This time, however, there might actually be something to it.
The Bureau of Labor Statistics said that consumer prices rose just 3% in June from a year earlier, the mildest year-on-year change since March 2021. Inflation watchers tend to focus more on less volatile measures of the “underlying” trend, but even the under-the-hood metrics seem to be pointing increasingly in the right direction. Core CPI, which excludes food and energy, was up just 4.8% from a year earlier (lowest since October 2021) while non-shelter core inflation was up just 2.8%. Yields on two-year Treasury notes fell about 16 basis points after the report, the most since May, extending the four-day decline to 0.27 percentage points. Meanwhile, the S&P 500 Index jumped 1.1% and appeared poised for the highest close since April 2022. Compared with last summer’s mirage of a rally, this one clearly has some fundamentals for investors to hang their hats on.
So is the Fed done raising interest rates? And could it actually cut sooner than previously expected?
To try to answer those questions, I’ll return to Powell’s framework for thinking about inflation, which he first outlined in a Brookings Institution speech in November 2022. At the time, he highlighted four key developments that he hoped to see in the economic data to know he had done enough to tame inflation:
Goods prices should “begin to exert downward pressure on overall inflation.”
Forward-looking market-based measures of housing inflation should continue to cool, and at some point in 2023, the lagged effect should filter into the main inflation gauges.
Non-housing core services — including health care, education, and hospitality — should be cool. Since those sectors are so sensitive to labor costs, Powell reasoned, the labor market needed to rebalance, and wage growth needed to slow.
Finally, the US should have a “sustained period” of below-trend GDP growth.
Let’s check the progress on those fronts.
Core Goods
Grade: A-
Excluding volatile food and energy, core goods prices clearly look like a deflationary force in the CPI. In fact, core goods look like the star of the latest report.
Thanks to a large decline in the prices of used cars and trucks in June, core goods inflation measured year-over-year clocked in at 1.3%. In the five years before the pandemic, core goods prices had typically been roughly flat on average — so they’re close to where they need to be, especially if you focus on the most recent report (which annualized to 0.7% deflation).
If only it would stabilize there. The index reflected some core goods deflation in late 2022 as well, but it proved short-lived, as used-car prices took another leg up. Jonathan Smoke, chief economist for Cox Automotive, told me Wednesday that the era of extreme whiplash may be behind us. Here’s how he put it:
"Demand over the last three years for autos has been more than the market could bear, and that’s precisely why we’ve had such tremendous inflation. But as we’ve started to enter this post-pandemic era, first we started to see the used-vehicle prices come down. And this year has been three months of crazy up increases, then three months of crazy downturns. But I think we’re at a turning point right now where the auto market returns to more balance for the foreseeable future, and that balanced market is likely to deliver small and predictable changes in both sales and prices because we’re not really expecting any of this to boost demand significantly and the market is still relatively constrained on the used vehicle side."
The Fed will be able to breathe easier when core goods inflation is not only low but also less volatile.
Housing
Grade: B+
Shelter accounts for a whopping 32% of the CPI and about 17% of the personal consumption expenditures deflator, the Fed’s preferred gauge. It is extremely important and also incredibly confusing to interpret.
The main issue is that only a small fraction of renters renew their leases every month, and yet inflation indexes attempt to capture the experience of all of them. In practice, that means that shelter inflation in the CPI is slow-moving and inertial, lagging the market rents on Zillow and similar data providers by many months. To many observers, the CPI and PCE appear to be “artificially” inflated by rent spikes that are already yesterday’s news. But conceptually, the inflation indexes are accurately measuring what they’re intended to.
The good news is shelter inflation is relatively predictable using market gauges, and rent disinflation appears to be on the way. According to Bloomberg Economics’ model, rent and owners’ equivalent rent inflation in the CPI should fall to less than 6% year-on-year by December. In the latest report, owners’ equivalent rent of residences rose 0.4% from a month earlier; measured year-over-year, it was still a daunting 7.8% but has clearly rolled over.
Knowing the lags, StoneX Chief Market Strategist Kathryn Rooney Vera told me that the Fed may start to look through housing inflation to “a certain extent” — but it’s not ready to ignore it yet. Here’s how she put it on Wednesday:
"It’s such a mighty component of CPI and core PCE that it’s really hard to discount it to a great extent. Housing inflation should continue its slow descent. It hasn’t moved as quickly as one would expect, given the jump in rates and the surge in pricing making affordability so difficult. But owners’ equivalent rent inflation ... and primary rents slowing — that’s all good news."
To be sure, there have been a few signs that the housing market may have bottomed recently and begun a tepid recovery. The Fed will gladly tolerate a modicum of “normal” housing inflation, just not a return to the 2021-level frenzy.
Non-Housing Core Services
Grade: B+
That brings us to the last of the inflation categories Powell identified in November: non-housing core services. That category makes up more than half of the core PCE deflator and about a third of core CPI, prompting Powell to call it perhaps the “most important category for understanding the future evolution of core inflation.” At the time of his Brookings remarks Powell reasoned that the labor market held “the key” to understanding that category because wages were the largest cost for non-housing core-services companies.
On this front, the outlook seems encouraging as well, but its future is a bit tricky to divine with a high degree of confidence.
First, the good news. The CPI version of Powell’s non-housing core-services gauge — or supercore, as it’s become known — was essentially flat last month (neither inflating nor deflating.) On a three-month annualized basis, that implies inflation in the category of about 1.4% — actually below the roughly 2.2% supercore CPI inflation that prevailed in the five years before the Covid-19 pandemic.
Conceptually, of course, the CPI has some significant differences from the PCE deflator in how it measures this category, especially when it comes to medical care services, and we’ll have to wait for more information to see how the category is trending in the Fed’s preferred gauge. (When producer price index data is released on Thursday, analysts will be able to use that to back into the implied PCE inflation.)
Even if he gets an encouraging report or two on that front, Powell is likely to worry about non-housing core-services inflation until he sees what he’s called “the restoration of balance between supply and demand in the labor market.” According to Powell, the US needs only about 100,000 jobs a month to accommodate population growth, but Bureau of Labor Statistics data suggests the US is still adding more than double that at about 244,000 on average over the past three months. Average hourly earnings are up about 4.4% from a year earlier, while Powell has said he’d like to see something closer to 3% wage growth.
Policymakers would gladly welcome disinflation without a cooler labor market. But until it happens in full, they’re likely to remain skeptical.
Below Trend GDP
Grade: B-
While growth briefly contracted in early 2022 (albeit for idiosyncratic reasons), it reaccelerated in the second half of last year and has stayed relatively strong.
At a seasonally adjusted annual rate, real GDP expanded 2% in the first quarter, just above the Congressional Budget Office’s 1.8% estimate of potential GDP. For the second quarter, the Atlanta Fed’s GDPNow tracker puts the rate at about 2.3%. While forecasts still call for a second-half slowdown (or even contraction), it’s hard to conclude that it’s already happening in the data.
Needless to say, subdued real GDP growth is simply a means to an end, and if inflation continues to meaningfully moderate without it, Powell and his colleagues will gladly learn to live with it. If that happens, it would upend decades of central banking orthodoxy. But the latest bout of inflation certainly started, in large part, with supply chain constraints, and it’s theoretically possible that supply normalization itself could cool inflation without crushing demand.
As with the labor market, they’ll believe it when they see it.
Big Picture
All told, the inflation picture is clearly improving, which may well fan the flames of another summer bond rally. With another report like that in August, the optimism may be hard to contain.
In practice though, this report alone isn’t likely to change the path for policymakers. With the labor market and economy still hanging tough, odds are that the Hawks will seize the opportunity for one last rate increase later this month, although the odds of another in September have diminished meaningfully.
After that, the Fed will probably hold rates steady until 2024 and try to play down chatter about a pivot to lower rates. But that won’t stop bond yields from racing lower in anticipation of better times ahead. Last summer’s “pivot rally” was a head fake, but there may just be something to the latest July optimism.
A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out our most recent white papers.
Bloomberg News provided this article. For more articles like this please visit
bloomberg.com.
