Inflation Report Surprises Fade Rate Cut Prospects

by | Apr 16, 2024 | Economic Perspectives

The hotter than expected February CPI data had faded the odds of a May rate cut. The hotter than expected March CPI data has greatly faded not only the odds of a June cut (with market odds now just 30%) but even threatened the likelihood of a July cut (market odds just 66%). Given all the uncertainties around not only macro data but also geopolitics, it is tough to argue that there are no material question marks around the near-term direction of monetary policy.

However, June is still “live” in our opinion and we would view a delay beyond July as an outright policy mistake. There are several reasons for this. The most important is the same level calibration argument we’ve been making for months. Even with recent stronger than expected prints, the Fed’s inflation target (core PCE) has retreated from 4.8% y/y in April 2023 to 2.8% y/y in February 2024 and should inch at least another tenth lover by the June meeting. If a 5.5% Fed Funds rate was appropriate in April 2023, it no longer seems appropriate now, not unless one expects some sustained reacceleration in demand and/or sustained and intense disruptions to supply chains. We do not. The second reason is that monetary policy works with very long lags, so in essence the Fed in June of 2024 is truly making policy not for June of 2024 but more for June of 2025. We do not forecast a US recession, but even as one acknowledges the large demand boost from lingering fiscal stimulus and high immigration that has dampened the impact of high interest rates over the last year, that boost fade sequentially going forward. Debt refinancing risks do not fade, they get closer. And excess savings don’t get rebuilt, they get used up. The third reason is that there are costs to the type of month-by-month approach the Fed has chosen to pursue. It forces it to over-respond to the vagaries of the data and to inevitable data noise. There is no longer much of a signal to market participants (beyond a “let’s all wait for the data” guidance) and there is a lot more volatility. Lastly, timing matters. If the Fed were to delay rate cuts beyond July, the next chance for a cut would come in mid-September, when the US would be already deep in election fever and after that, two days after the election. Neither of those is ideal for the initiation of a cutting cycle, nor for a bigger cut, which may become necessary by that point. This is why the market has swung wildly and is now pricing less than two cuts this year: it sees the Fed backing itself into a corner that takes away its ability to act even as acting is needed. We believe that Initiating the cutting cycle earlier helps the Fed retain more flexibility and control over the process.

Now back to the inflation data. Both overall and core consumer prices increased 0.4% m/m in March, more than expected. Both rounded up to 0.4% and for the core measure this was the second consecutive month of a very low 0.4% print insofar as the last two readings actually were 0.358% in February and 0.359% in March. This further emphasizes the problem we discussed earlier, namely the over-emphasis of data points versus data trends. Goods prices rose 0.1% and services prices increased 0.5%. On a y/y basis, overall inflation ticked up three tenths to 3.5% y/y while core inflation was unchanged at 3.8% y/y.

The main reasons for the strong print remain energy and shelter. Some parts of this were expected and others a bit surprising. For instance, we had fully expected to see gasoline prices rise again, and they did (1.7% m/m) but we though energy services would reflect declines in piped gas prices, but they did not. Overall energy costs rose 1.1% m/m. Food prices were well behaved for the second month in a row, with food at home unchanged and food away from home up a reasonable 0.3%. Shelter costs increased 0.4%, as did OER (owner equivalent rent). Both matched the February print. The problem here is that we need to see these metrics step down a little to the 0.3-0.4% range in consistent fashion and this has not happened yet. It is somewhat puzzling that they have not given market data on rents. Immigration likely has something to do with this even if many recent immigrants tend to find housing with family members already in the country. Even so, rent of shelter inflation has moderated from a peak of 8.3% y/y in March of 2023 to 5.7% y/y in March. We have recently raised our rent inflation forecast for the remainder of the year in recognition of the persistent resilience in the data, but we still expect shelter inflation to ease to the mid-4.0% y/y range by the end of the year.

Both new (-0.2% m/m) and used (-1.1% m/m) vehicle prices declined slightly, but not as much as we thought they would, especially the latter given more substantial declines reported in used vehicle auction prices. Apparel prices posted another large 0.7% m/m increase, which is unusual. Within services, medical care prices jumped 0.5% after a flat reading the month before. This is not all that surprising as the low February reading was unsustainable, but we are hoping to see at least some improvement here in coming months. Recreation services declined 0.1% m/m, which again may not prove sustainable, but we are seeing a trend of modest deceleration here that speaks to a more price sensitive consumer. The slight decline in the category obscured some big discrepancies among sub-components. There was a big (huge, really) surge in the “purchase, subscription, and rental of video” in March that most likely reflects one-off price adjustments, while admission prices declined. The former is now up 30.1% y/y while the latter is up 6.4%. Not all services are created equal, and not all recreation services are created equal, either!

There are two areas of intense inflationary pressures in the US economy at the moment: insurance services and repair services. Medical insurance is a special case given oddities around management and we do not take issue with the increase there as primarily about normalization. Vehicle insurance is a little different (Figure 1, page 3). Vehicle insurance costs were 22.2% higher y/y in March. Up to a point, this simply reflects higher replacement costs. However, we also see some evidence of opportunistic pricing in this space. For instance, vehicle insurance costs are up over 40% since pre-Covid, whereas new vehicle prices are up about 20% and used vehicle prices are up about 30%. Overall prices are also up about 20%. So at the very least, one should expect that we are close to a peak in this category already rather than bet on further meaningful acceleration. Such further acceleration may still happen if insurers find they can push through price hikes, but at this point these increases are less and less directly driven by underlying costs. As used car prices come down further (auction prices suggest they should), we may get some lagged relief in this space. However, the “lag” concept is important here and echoes some of the issues surrounding rental inflation computation. Just like rents, insurance contracts renew only periodically and so the peak in insurance cost inflation naturally lags the peak in underlying replacement cost inflation. But just like with rents, the lag may be long, but it is finite. Relief will come.

Repair costs are also through the roof, whether for motor vehicles or household items. Labor costs play a larger role here, and so it is to be expected that price pressures will not fade quickly. The strength of these readings is a concern for the Fed, but the Fed can take some solace in the fact that wage inflation has actually moderated markedly and supply chain stress has also eased markedly, suggesting that these high current readings are unlikely to persist for much longer.

Elsewhere, producer and import price inflation were better behaved and offered a marginal repriced from the CPI-induced market sell-off. PPI- final demand inflation for final demand came in at 2.1% y/y vs 2.2% expected, while import price inflation came in at 0.4% y/y vs 0.3% expected. On a m/m basis both PPI and import prices were pretty well behaved.

One of the core reasons why we persist in our disinflation belief despite the recent string of higher than expected prints is that we are of the view that the labor market is looser than the employment data alone suggest. The NFIB index this week offered another argument in that respect, as the hiring intentions sub-component dropped again. In fact, aside from three months at the start of Covid, that metric has not been lower in seven years. Given that job openings are relatively most elevated at firms with sub-50 employees, this gives at least a reason for pause. Some have argued that openings are elevated because there are a lot of new businesses being created and those are unlikely to be yet part of the NFIB sample. There probably is some truth to that. But it is odd to thing that times are so good that so many people are starting lots of new small businesses that are looking to hire so many people, yet so bad that existing small businesses see little reason to boost their own payrolls.

☕️🐻 Webinar: Coffee with CalTRUST | March 20, 2025
☕️🐻 Webinar: Coffee with CalTRUST | March 20, 2025