October's CPI report provides several reasons for optimism on inflation
Following the CPI preview I published yesterday, I provide this short update in order to assess how the key points that I highlighted evolved in the latest data. Broadly speaking, there were plenty of positives to draw from the latest CPI report.
As I have been stating for months, inflation likely peaked in June. My confidence in this stemmed from the initial flatlining, and now consistent outright MoM declines in the M2 money supply. The main problem remains the fact that the CPI and PCE BOTH use a lagging measure of shelter costs, which greatly increases the risk of the Fed overtightening and causing a severe recession - let’s dive in!
1) The major deceleration in durables prices quickens - on track to be less than 2% YoY by December
The first key thing to note from the October CPI report is that the ongoing deceleration in durables prices has quickened, with the second biggest EVER MoM decline in September being followed by a MoM change of -0.6% in October.
I was expecting a high chance of another negative number given the seasonality that is traditionally seen in durables prices, though yet again, the current MoM change was MUCH stronger than its historical average - and these historical averages are already consistent with YoY deflation! Importantly, this seasonality has historically continued through to December, meaning that additional negative MoM changes appear likely to to be recorded in November and December.
Given high prior comparables to be cycled until January, and with the last two months of durables price data indicating a much stronger decline than the average of prior years, I now expect YoY durables prices to fall well below 2% by December (versus my previous base case of January 2023). YoY durables price growth now looks increasingly likely to fall well below 1% by January 2023, and potentially return to outright YoY price deflation by June 2023. I will have more to say on this in an upcoming update once my longer-term inflation forecasts are finalised.
2) Energy commodities rise as expected, but could see YoY declines by March
After gasoline prices rose in October, it was no surprise that the CPI’s energy commodities index saw a MoM increase of 3.6%. Nevertheless, this was enough to result in a further YoY decline in CPI energy commodities from 19.7% in September to 19.3% in October. Importantly, gasoline prices in November are so far roughly in-line with their average October level. This is important as there does NOT need to be a decline in gasoline prices in order to achieve a significant benefit for the CPI. If energy commodities simply stay at the level recorded in October, then the energy commodities index will turn NEGATIVE by March 2023.
While risks remain given the uncertain outlook for world oil supply on account of Western sanctions on Russia, with the US and European economies weakening significantly, and China continuing to be impacted by COVID lockdowns, a rough flatlining in prices looks as if it has a decent chance of occurring.
3) MoM growth in food prices remains high, but expecting relief to not be too far away
An important factor which I was on the lookout for in this month’s CPI report, was a MoM deceleration in food prices. The reason for this was the ongoing decline in underlying food commodity prices that the UN FAO’s Food Price Index has now recorded for seven consecutive months. While the CPI recorded a third consecutive month of MoM price deceleration, the decline has remained very modest, with a MoM change of 0.70% (vs 0.73% in September and 0.76% in August). Given the historical correlation between the UN FAO Food Price Index and the CPI’s food prices on a 6-month lagged basis, I continue to expect that a more significant moderation of food price growth in the CPI, should not be too far away.
4) Health insurance revision helps deliver big deceleration in services ex-shelter
Perhaps the most positive news of all on the inflation front was the MAJOR deceleration in the services ex rent of shelter component, which was basically flat MoM. This was a huge drop-off from recent monthly growth rates.
While I would want to see this repeated for another month or two to confirm such a significant potential shift, there is one VERY important factor to note which helped to drive this deceleration - importantly, we also KNOW that this will continue to support lower services prices over the next year. That factor is the BLS’ yearly adjustment to the CPI’s health insurance component.
Instead of directly recording monthly health insurance costs in the CPI, the BLS instead indirectly measures health insurance costs based upon the retained earnings of health insurers. The BLS computes this measure ONCE per year, with the overall change being reflected across the rest of the year in fairly evenly spread MoM changes.
In October 2021, this adjustment saw a MoM increase of 2%. Over the year to September 2022, individual MoM change averaged 2.1%, with the YoY rate peaking at 28.2% in September 2022.
In October 2022, the BLS re-adjusted the figure DOWNWARDS by 4%! While the health insurance component is only ~0.9% of the overall CPI, this is an ENORMOUS ~6 percentage point divergence. Instead of peak annual growth of 28%, the annual rate of health insurance growth now looks likely to be closer to NEGATIVE 40% come September 2023.
The impact of this shift on the broader medical care services component (~6.9% of the CPI) in October was significant, with this component seeing its MoM change falling from +0.7% in September to -0.5% in October!
5) As expected, shelter cost growth remains high - the Fed likely NEEDS to adjust inflation measurements for market rents
As has been the case for many months now, a major inflationary driver in this month’s CPI was the shelter component. This was expected to again be strong given the lagging nature of rent measurement in the CPI versus spot market rents.
While a lower portion of new leases from November-February, and a gradual convergence of the CPI’s rent related indexes to current market rental rates should see this figure begin to soften overtime (of which it seems October may have provided a small taste of), there is likely to be at least several months of relatively high MoM CPI rental price growth ahead.
Given that 1) durables prices are rolling over VERY quickly; 2) gasoline prices are set to see SIGNIFICANT YoY declines by March should prices remain around current levels; 3) food price deceleration is likely to soon occur given falls in underlying food commodities; and 4) an abrupt shift in health insurance cost measurements, which is effectively baked in until September 2023, the lagging nature of rent measurement becomes all the more critical as it greatly distorts the underlying inflation picture.
As I have been continuously warning, the lagging measurement of rents in the CPI risks SIGNIFICANT overtightening from the Fed, and greatly increases the chances of a SEVERE recession. The increasing tailwinds for lower inflation over the next 6-months greatly heightens the NEED for the Fed to begin more closely incorporating market rents into its inflation analysis, and articulating to this to public. The costs of not doing so, could be extremely significant.
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Hey Steven,
thank you for your research. It is pretty interesting and very well written. Just to sum things up: if you expect lower inflation, lower interest rates in next 6 -12 months and re-opening of QE and ZIRP, wouldn't it be a good idea to buy longer term govt bonds (10 / 30 years)? What do you think?
I appreciate the way you look at each component that makes up the CPI. Great write-up.