The CPI for December was slightly hotter than expected, up +0.3% from November (which in turn only rose +0.1%). The market expectation was for a +0.2% number. As a result, the headline CPI, which looks back 12 months, kicked up to 3.3% in December from November’s 3.1% read.
The Core CPI (ex-food and energy), however, was in line with expectations at +0.3% on a month/month basis, unchanged from November. That brought the year/year number down to +3.9% for December from November’s 4.0% print. And when one looks at individual prices, especially on the goods side, the path appears to be moving to the downside. The chart shows a long list of falling prices in December, including eggs, tomatoes, apples, fuel oil, gasoline, airline fares, furniture, and toys, to name just a few. While the headline inflation rate is a year/year calculation, the three month annualized rate tells us what has recently happened and gives us a better read on the trend going forward. Over the past three months, the annualized rate of the CPI is a quite modest +1.8%.
The lagged shelter component of the CPI (a 35% weight in the index) came in at +0.4% in December versus +0.5% in November. According to Apartment List’s December report, “The rental market closed out 2023 with a fifth straight month of negative rent growth, as the nationwide median rent fell by 0.8 percent…” Excluding rents, the year/year growth rate of the CPI stands at 2.5%, and, if the -0.8% Apartment List Index number is substituted for the rental component, then the actual year/year inflation rate is closer to +1.6%, significantly under the Fed’s +2% target.
On Friday (January 12), the PPI (Producer Price Index) showed up with results just opposite of the CPI. It was -0.1% for the month of December, and up a mere +1.0% for the year. This is a large fall from its +6.4% year/year reading as of December 2022. Markets were expecting a +0.2% reading for the month, so a big miss. Of greater importance, the miss was to the high side. Core PPI (ex-food and energy) at +0.2% was right in line with expectations. PPI’s six-month annualized rate is -3%; and its three-month PPI is generally considered a leading indicator for consumer inflation as it measures prices at earlier stages of production.
The Fed’s Reaction
The question is, will these reports change when the Fed begins to reduce interest rates? Potentially, they could. The Fed meets at the end of January (30-31) and then again in March (19-20). These were the last CPI and PPI reports before the January meetings. Because the reports were not of one voice, and, because the Fed is so backward looking when it comes to data, we don’t think rate cuts are on the agenda for January. The tone of the minutes and of Chair Powell at his press conference will be key in measuring the sentiment for faster/slower cuts. (But, cuts there will be!)
The market’s odds of a March rate cut fell to 65% post-CPI. However, post-PPI, markets are now pricing in a 79% chance of a March rate cut as they see the disinflationary trends that we see. By those meetings, the Fed will have two more CPI and PPI reports (January and February). If those reports show weakening inflation, as we expect, then there is a good chance for a rate cut. And by May, the downtrend in the lagged rental index used by BLS will finally be established, and the CPI will be behaving a whole lot better. Markets are pricing in total rate cuts of 150 basis points in 2024, from a Fed Funds rate of 5.25%-5.50% to 3.75% -4.00%. In our view, the cuts will be larger as the Fed heads at least to its neutral rate (2.5%).
After all the hoopla surrounding these two reports, consumers’ inflation expectations have continued to fall. Economists believe that expectations are key to future inflation. If the public believes inflation will be low, they will “revolt” against rising prices, thus keeping the rate of inflation down. On the other hand, if the public expects inflation, then when prices rise there is no “revolt,” i.e., rising prices are ”expected!” The fact that inflation expectations have been falling is a very good sign that “disinflation” will continue.
The Lowdown on Rents
As noted earlier, rents will be falling in the CPI calculation. Rents turned negative on a year/year basis last June. Sometime in the April/May 2024 time frame, the BLS methodology will finally begin to note what has been happening to rents.
The left-hand side of the chart shows the year/year change in national rents. Note the negative levels from mid-2023. The right-hand side shows the number of the country’s largest 100 cities with negative year/year rental growth. Note the rapid rise in the negative trend in the spring and summer of 2023, the peak in the fall, and that the number of cities with negative year/year rents has remained elevated through December.
In addition, apartment vacancies are on the rise at the same time that record numbers of new apartments, now under construction, will be coming on the market (see chart). Because of these trends, and because the BLS uses lagged data in the shelter computation of the CPI (35% weight), we are confident that we will continue to see falling inflation in 2024.
In recent blogs, Economist David Rosenberg has noted that the oncoming Recession has taken longer to manifest itself than would otherwise be suggested by the historical record. Clearly, part of this was due to the drawdown of what economists have called “excess savings,” i.e. the free money from Uncle Sam during Covid. Another part, says Rosenberg, is due to the stimulative impacts of the huge budget deficits run over the past couple of years. The level of the budget deficit is currently a hotly debated topic on Capitol Hill. This bites two ways. When the Recession does manifest itself, the economy will be less responsive, both because there is no excess savings left, and because we expect that smaller deficits lie ahead.
Another example of this is the low level of mortgage refinance applications. Most households currently have mortgage rates under 4% due to the ultra-low level of interest rates in the period after the Great Recession until the Fed’s recent rate hiking campaign. No excess savings and no refis means that the American consumer will be facing a cash crunch. We’ve already seen consumer delinquencies rise and credit card debt outstanding now at a record $1.3 trillion. In fact, we are amazed at the double digit growth rate of the new craze: “buy now, pay later.” We think there is precious little fuel remaining in the consumer’s tank.
- Despite the Wall Street narrative, we believe it is too late to stop the oncoming Recession. Its severity and duration, however, can be reduced if the Fed acts quickly and decisively. That, however, doesn’t appear to be in the cards with this particular Fed.
- Consumer debt has ballooned, and delinquencies are rising, as are business bankruptcies.
- As we discussed throughout much of this blog, disinflation is well established. We think that there is a strong likelihood that deflation will be an issue by year’s end.
- The “long and variable” lags in the transmission of monetary policy to the economy look to be on the longer end in this cycle when viewed from an historical perspective. We noted the reasons: free money and excessive federal deficits.
- The Fed, it appears, will take a very deliberative approach, waiting until the year/year data get to its stated 2% inflation rate before moving decisively. The disinflation (deflation) trends, however, will continue long after the Fed begins its easing cycle.
- Whether it first lowers rates by 25 basis points in March or May, we think it will be “too little too late” to avoid a Recession.
- In any case, interest rates will be falling in 2024. Bonds, especially longer duration, look attractive.
Robert Barone, Ph.D.
(Joshua Barone and Eugene Hoover contributed to this blog)