Reading the Tea Leaves Around Inflation

Telemus Weekly Market Review June 12th - June 16th, 2023

This past week, there were two notable economic events. The first was Tuesday’s release of the Consumer Price Index (CPI) for the month of May. The second was the Federal Reserve’s Open Market Committee meeting that concluded with a decision to leave interest rates unchanged, the first pause in their rising rate policy since the Fed started hiking rates over a year ago. 

The Consumer Price Index slowed in May, rising only 0.1%. This modest reading, benefited from continued declines in energy prices, which fell 3.6% in May. Over the last twelve months, the Consumer Price Index has fallen from 9.1% at the end of last June to 4.0% after May’s report. This measured decline shows clear progress in combating the inflationary trend.  

A less talked about indication from the May inflation report was the sticky trend in the Core CPI, or Consumer Price Index excluding food and energy prices. This measure is useful in that it removes more volatile commodities that can be less indicative of broad-based price movements. The Core CPI rose 0.4% in May and over the past year is up 5.3%. The Core CPI has hovered around the mid-5% range since December and shows little sign of going lower. The big contributors to growth in the Core CPI index are shelter, where costs are up 8% in the past year, transportation services, car insurance and used car prices. Used cars in particular stand out having risen 8.8% in the past two months alone. 

A useful research piece put out by the Federal Reserve Bank of New York studied what drives companies to raise pricesⁱ. The research concluded the key determinants were the strength of demand, a desire for companies to maintain profit margins, higher labor costs and prices charged by competitors. As we consider these drivers, we may have some signs that inflation (core inflation in particular) may have some hope of coming down. Economic activity readings would indicate that demand for goods and services is starting to soften. Reductions in input prices, as measured by the decelerating Producer Price Index, might indicate that companies may be seeing some relieve with profit margins. We’ve also seen anecdotes from corporate earnings transcripts where some companies have indicated they may be slowing the pace or price changes. These all would be indicative of the potential for fewer price hikes by companies. The one challenging factor is labor costs, which remain elevated at over 4% growth on an annual basis. Parsing through each of these pieces, it’s seems as if core inflation has the hopes of slowing, however, we think it will take time.

Following its meeting this week, the Federal Reserve Open Market Committee updated its economic projections. In those projections, they highlight their expectation that it may take time before inflation normalizes. They forecast core inflation not hit a level near their 2% target until 2025. Given this expectation for a slower and gradual normalization in inflation, the Fed also suggested that interest would go higher than they presently are and would likely remain higher for longer. Presently, the expectation among the Fed is that rates will be a half percentage point higher at the end of 2023. Rate cuts are expected to be more modest and gradual during 2024 and 2025. 

Both the stock and bond market has been rather defiant of the rhetoric coming out of the Fed. Market expectations for much of the year had been that the Fed would be cutting rates at some point in 2023. Following this week’s announcements, those expectations are starting to reset with expectations embedding a higher for longer interest rate cycle. The risk remains to the upside, as an inability to begin cooling core inflation may push the Fed to hiking more than expected. Moreover, markets seem anxious for the Fed to begin cutting rates. During his post meeting press conference, Fed Chairman Jerome Powell stated it might be a couple years before they consider cutting rates. The market does not yet seem ready to accept a timeline of that length. 

Our assessment of the past week is that the Fed’s actions have clearly helped to bring stability to inflationary pressures. However, inflation remains stubbornly high. Evolving economic conditions would suggest that key determinants of rising prices, as indicated in the New York Fed’s research, may become more supportive to disinflationary pressures over time. However, investors should not yet assume the checkered flag has been waved on the battle with inflation. 

ⁱ Federal Reserve Bank of New York. Liberty Street Economics, June 2, 2023. https://libertystreeteconomics.newyorkfed.org/2023/06/how-do-firms-adjust-prices-in-a-high-inflation-environment/  

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