March US CPI review: the disinflationary cycle continues, but will the Fed erroneously focus on core inflation?
While headline CPI growth continues to decelerate, the exclusion of food & energy prices meant that core CPI growth rose. It would be a mistake to focus on core, as opposed to headline inflation data.
Executive summary
US CPI growth fell from a YoY growth rate of 6.0%, to 5.0% in March.
Core US CPI growth rose from a YoY growth rate of 5.5%, to 5.6% in March.
Both measures were slightly below my estimates for CPI growth of 5.2% (5.2% consensus), and core CPI growth of 5.7% (5.6% consensus).
As expected, CPI used car & truck prices rose in March but by less than anticipated.
As expected, a large double-digit YoY decline in the CPI’s energy commodities component drove the bulk of the large moderation in headline CPI growth.
Having expected a further moderation in CPI food at home prices, the moderation stepped up a gear in March, with a MoM decline recorded.
While I had expected a further moderation in the CPI’s lagging rent based components, both owners' equivalent rent (OER) and rent of primary residence (RPR) recorded a particularly large MoM moderation in March.
The combination of sharply moderating/declining food and energy prices means that the second phase of the disinflation cycle picked up in pace — this is expected to lead to further material reductions in the CPI’s growth rate over the months ahead.
Given its exclusion of food and energy prices, the core CPI largely excludes any benefit from the second key phase of the disinflation cycle, while it continues to remain pressured by lagging services price growth.
Given that many, including the Fed, pay significant attention to core prices, the inability of the core CPI to capture the second key phase of the disinflation cycle, risks significant additional Fed overtightening.
Markets have become more attuned to this risk following the CPI report, increasing their expectations for the future federal funds rate.
In March, the US CPI saw its YoY growth rate fall from 6.0% to 5.0%, while the core CPI rose from 5.5% to 5.6%.
This compared to my estimate of 5.2% for headline CPI growth, and 5.7% for the core CPI.
Used car prices rise, but by less than expected
One reason for the lower than expected inflation readings, was that used car prices rose by a significantly smaller amount than I had anticipated.
To refresh, CPI used car & truck prices (which measure retail prices), generally lag the Manheim Used Vehicle Value Index (which measures wholesale prices), by two months.
Given that the unadjusted Manheim Used Vehicle Value Index (Manheim Index) rose in January, I had expected CPI used car & truck prices to rise in March — this occurred. Though the extent of the rise was materially softer than I had anticipated.
While a simple read-through of the Manheim Index from January would point to a MoM increase of 1.5% for CPI used car & truck prices in March, the Manheim Index also saw further substantial gains in February and March (up 3.7% and 3.5% respectively). This suggested a buildup of additional price pressure that could see CPI used car and truck prices rise by an amount that was somewhat above the simple 1.5% read-through.
Despite this, CPI used car & truck prices rose by only 1.0%. This suggests that the strong growth that had been seen in wholesale prices is not translating as strongly to the retail level, which may suggest relatively weak consumer demand. Should this persist, wholesale price growth may moderate/decline over the months ahead, as dealers adjust how aggressively they replenish their inventory.
Energy commodities drive the big CPI deceleration — now down 17.0% YoY
Driving the major deceleration in the CPI, was the CPI’s energy commodities component, which is now down 17.0% YoY. This comes as gasoline prices have fallen significantly over the past year, with U.S. Energy Information Administration data showing that monthly average regular all formulations gasoline prices had declined 18.9% over the year to March.
The moderation in food at home prices goes up a gear as prices fall in March
After MoM price growth began to moderate back towards its historical average (across 2010-19) in 2H22, the moderation stepped up a gear in March, with food at home prices seeing a MoM decline of 0.2%.
This marks the first time since January 2021 that MoM CPI food at home price growth was below its historical monthly average, breaking an extraordinary streak of 25 months of higher than average MoM price growth.
The moderation in MoM CPI food at home price growth comes as the UN FAO Food Price Index, which typically leads CPI food at home prices by ~6 months, has seen 12 consecutive MoM declines.
There’s thus strong reason to suggest that the YoY growth rate for CPI food at home prices will continue to moderate significantly over the months ahead.
Though more services oriented food away from home price growth remains high
While CPI food at home prices are moderating as declining wholesale food prices flow through to retail prices, CPI food away from home prices, which includes services like restaurants, remain well above their historical MoM average.
This points to the broader difference that currently exists between nondurables, and services price changes, with the latter being significantly more lagging and continuing to generally see material growth.
As a result, while CPI food at home prices saw their YoY growth rate peak back in August 2022, CPI food away from home prices continue to rise, reaching a new peak for the current cycle of 8.8% in March.
Rent based indexes saw a major MoM deceleration
The CPI’s rent based indexes saw a major deceleration in their MoM growth rate in March, confirming that the lagging CPI indexes have sufficiently caught up to spot market rents, to now allow for a deceleration to take place.
Given that the CPI’s rent based indexes are not only lagging, but generally move in a relatively smoothed manner, as only a fraction of the sample consists of new leases in any given month, it’s somewhat unusual to see such a large MoM shift. As such, I wouldn’t be surprised if there was some bounce back in April. Though the general direction and trend appears to now be clearly headed one way — down.
Motor vehicle maintenance prices see another month of more modest growth
Upon reviewing the CPI’s February numbers, one item stuck out — motor vehicle maintenance prices. After seeing very high MoM growth rates for most of 2022 and in January 2023, they suddenly moderated significantly in February, with MoM growth coming largely in-line with its historical growth rate.
While rising slightly in March, MoM price growth remained much less above its historical average than it had from June 2022 to January 2023. This further suggests that a step change to more moderate MoM growth may have taken place.
But overall core services prices continue to remain high
While the potential for an ongoing moderation in motor vehicle maintenance prices would be a positive, the overall core services price equation continues to remain one of much higher than usual MoM price growth.
While core services saw lower MoM price growth in March, much of this was due to typical seasonality, with March tending to be one of the weaker months for core services price growth. MoM core services price growth continued to be much higher than its historical average in March.
Though it’s important to note that this also includes the significant benefit from the indirectly measured CPI health insurance component, which after seeing an enormous rise in 2022, is now seeing an enormous technical adjustment to the downside in 2023, in a manner that is not consistent with the PCE Price Index.
If this component is excluded, one can see that core CPI services prices continue to remain well above their historical average.
Lagging core services prices risk higher core CPI growth and significant additional Fed overtightening
A consequence of focusing on core services prices, is that they are a particularly lagging metric.
Taking the current high inflation cycle as an example, one can see that the most leading indicator of price changes is the M2 money supply, followed by durables prices, followed by nondurables prices.
As a result, once the M2 money supply rose and fell, durables prices followed in the same manner. Nondurables prices were the next to rise, and they are now decelerating sharply, as both energy commodities and food at home prices are declining/decelerating.
Core services prices are instead the most lagging indicator. They didn’t see a large burst of price growth, and their prices are now remaining elevated, as they slowly incorporate the changes that have already occurred in the money supply, durables, and nondurables prices.
Taking stock of where we are in the disinflation cycle, makes it clear why focusing on core inflation would be an erroneous metric.
With CPI durables prices currently seeing YoY deflation, the first phase of the disinflation cycle has already completed.
Instead of being something that should be excluded on account of its “volatility”, food and energy prices instead incorporate the bulk of the second phase of the disinflation cycle.
This is why the headline CPI continues to decelerate, and it is also why looking at the “core” inflation picture, which excludes food and energy prices, is erroneous — for it ignores a vitally important component of the disinflation cycle.
As a result, the consequence of focusing on “core” inflation, is that one is likely to misinterpret that inflation remains too high or too “sticky”, when in fact it is simply more lagging, as it skips the benefit of the second phase of the disinflation cycle, and needs to wait for the third and final phase of the disinflation cycle to begin (being a peak and moderation in core services price growth), before it will report lower rates of inflation.
Given that the Fed often talks about “core” prices providing a better picture of “underlying” inflation, this risks significant additional overtightening from the Fed, in the form of additional rate hikes, and in the form of the length of time that rates will be maintained at high levels.
Seeing this reality, the market has moved to price in higher rates
With higher core CPI inflation risking additional overtightening from the Fed, the market has moved to price in higher interest rates following March’s US CPI report.
For the upcoming May meeting, the odds of another 25bp increase have risen from 72.9% on the day before the latest CPI report, to 84.5% on 20 April.
Looking further out, an additional interest rate hike has been priced into expectations for December 2023. Markets now anticipate that rates are most likely to end the year at 450-475bps versus 425-450bps before the March CPI report.
Markets are now also pricing in a 22.9% chance of rates ending the year at 475-500bps (their current level), versus odds of 11.3% before the March CPI report.
Thank you for reading!
I hope you enjoyed reading my latest review of the current US CPI data.
A key focus of mine has been, and continues to be, to provide you, with a comprehensive picture of inflation. You can thus continue to expect to see monthly CPI previews & reviews, as well as research pieces that help to explain the theory underlying price rises, with a particular focus and analysis on its key driver — the money supply.
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Amazing breakdown for a beginner like myself trying to understand what it all means. Thank you!