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Fed’s Dilemma – Hotter Inflation & a Cooling Economy + Why Inflation is so Hateful

Inflation was the main concern of markets this week. On Tuesday (March 12th) Consumer Prices (CPI) came in slightly hot, but within market expectations. As a result, the financial markets took the report in stride and equities rallied. The problem was Thursday’s Producer Price Index (PPI), an index that is a leading indicator of future CPI inflation. The change in that index (+0.6%) was twice what markets expected (+0.3%) and the financial markets (both equities and fixed-income) sold off and equities ended the week with their first weekly loss (although only slight) in quite some time. The Fed isn’t going to like these inflation reports, and the chances of a rate cut in June  (as of March 14) now stand at 61%, down from 74% (March 7).


February’s CPI headline and core growth rates were +0.4% moving the crucial annual reading to 3.2% from 3.1% for the headline number and a more problematic 3.8% for core. While the headline year/year number ran up +0.1%, the actual change in that annual rate was +0.06%, i.e., .0006 in decimal form. While going in the wrong direction, this wasn’t a huge deviation from the downtrend in inflation.

February’s price increases were narrowly based. Shelter costs (+0.5%) and gasoline (+6.3%) represented 60% of the increase in the headline number. Airfares, freight costs, delivery services, and auto insurance rounded out the culprits. As explained later, shelter costs are based on year-old data and will be dragging CPI down in this year’s second half. We note that prices at hotels/motels and restaurants, and of new cars, furniture/appliances, clothing, and medical care either stayed the same or fell.


Then on Thursday (March 14), the Producer Price Index (PPI) for February came in much hotter (+0.6%) than the +0.3% consensus estimate and double January’s +0.3% rise. That raised the year/year growth rate to +1.6%. It was +1.0% as of January. This was the fastest growth rate since last September. The core PPI (ex-food and energy) rose a little slower at +0.4%; but that was still above the +0.3% expectation. The core year/year rate ticked up to +2.8% from 2.7%.

To say these two inflation reports won’t sit well with the Fed, which holds its meetings on Tuesday/Wednesday (March 19-20), is an understatement. What’s worse is that PPI is a leading indicator of CPI. We don’t expect rate cuts anytime soon, and we may even see a more hawkish dot-plot as a result.

Retail Sales

February’s Retail Sales were also reported on Thursday. At +0.6% higher than January, they disappointed the +0.8% expectation. To make matters worse, January’s Retail Sales number was revised to -1.1% from -0.8%. Adding things up, so far in 2024, Retail Sales are off -0.5%; not a good start for the year. Adjusting for inflation and looking at this in real (volume) terms, Real Retail Sales in February grew just +0.1%, and through the first two months of the year, the annualized growth rate is more than -7%. This portends ill for Q1’s GDP growth. Both the Atlanta Fed’s and St. Louis Fed’s Q1 GDP forecasts sit at 2.3%. We think growth will be much slower than that.

Why Inflation is So Hateful

In past blogs, we’ve reported that the rate of inflation is falling; the current headline CPI is 3.2%. It was 9.1% in June ’22. That’s good news – right? Or is it?

If the “rate” of inflation keeps up at February’s monthly headline rate, something that costs $100 today will cost over $103.20 next February. In reality, prices are still rising! People want prices to stop rising which means a CPI monthly growth of 0%.

Going back to December 2020, the CPI index was 262.005. February’s number was 311.054, So, in the ensuing three years and two months, prices, on average, have risen 18.7%. The price of gasoline is up more than 30% over this time frame and the price of food is up 21%. When the politicians say, “look, the rate of inflation at 3.2% is down from 9.1%,” people get angry because prices are still rising.

From an intellectual point of view, why does the Fed want 2% inflation? That means in 10 years, something that costs $100 today will cost nearly $122! The 2% inflation goal came from the “Bernanke” Fed. Supposedly, the logic is that a small amount of inflation lubricates the economy. To that, we say Nonsense! Even back in the immediate post-Great Recession period, when 2% became the inflation target, Alan Greenspan, former Fed Chair, questioned that 2% bogey saying “Why not 0%?”


We do think that, before 2024 is over, inflation will turn to deflation. Here’s why: the shelter component of the CPI has a 36% weight in the index. Excluding shelter, the prices of the other 64% of the CPI are growing at a +1.5% annual rate. BLS’s shelter index is lagged about 12 months. We know that rent “increases” turned negative in the second half of ’23 (see chart). The math implies that, if the non-shelter portion of the CPI stays at a +1.5% annual rate, when the negative rental growth is accounted for in the second half of this year, the headline CPI will be somewhere near -0.7%! In the chart, the red line is up to date tenant rents, the blue line is the shelter component of the CPI. Note where the blue line is headed.

What’s the Fed to do?

Nevertheless, because February CPI and PPI were hotter than expected (CPI rose at the fastest pace since last August), the Fed’s “higher for longer” position on rates is sure to continue. There is no chance of a rate cut at this week’s Fed meetings (March 19-20). As noted above, even the chance of a rate cut by June are only a little better than 50-50.  There is also a strong possibility that the March set of dot-plots could show fewer rate cuts in 2024, i.e., two, than the last dot-plot set (December) which showed three. If this is the case, expect a slight back-up in rates.

Final Thoughts

The rest of the world has slowed dramatically. China appears to be in Recession, and Germany and Japan are on the doorstep, if not already there. The fact that exports fell in Q4 means that the rest of the world has slowed.

The U3 unemployment rate has risen +0.5 percentage points from its low, a reliable indicator of Recession when it rises that much. The Regional Federal Reserve Bank surveys all show weaker manufacturing, and capacity utilization is off -3.3 percentage points. As noted above, Retail Sales, year to date, are negative when compared to December, and the consumer’s credit card debt is at record levels with delinquencies rising. Q4/’23 looks to us to have been last gasp spending.  As noted by David Rosenberg, “…the ‘resilient consumer’ narrative is definitely getting a little creaky…”

February’s inflation reports, both CPI and PPI, disappointed; both came in hotter than expected. That is sure to have an impact on this week’s FOMC meeting. While the Fed’s own Beige Book (comments from business and industry leaders in each Reserve District) indicates weakening demand and inflation, the Fed will need to reinforce its credibility with a continuation of the hawkish “higher for longer” stance. We expect the fixed-income markets not to react much (rates have already risen slightly in anticipation) unless the March dot-plot moves to less than the three rate cuts that were in the December version. If the dots move to two cuts in 2024, a June cut, already only at a 61% chance, will be priced out. That will leave only three remaining meetings (late July, mid-September, early November) for possible rate cuts.

One other consideration for the Fed’s rate cutting plans: economic growth (i.e. Q1 GDP growth). Both the Atlanta and St. Louis Regional Federal Reserve Bank models are calling for +2.3% Q1 GDP growth. As noted above, we think it will be much lower. The initial Q1 GDP print will occur at the end of April, just in time for the April 30-May 1 Fed meetings. A very weak GDP number may jump start the Fed into action.

Robert Barone, Ph.D.

(Joshua Barone and Eugene Hoover contributed to this blog.)


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