Disinflation Was Broad-Based in June
The bears got pummeled by Goldilocks this week.
The June consumer price index (CPI) report showed prices rising at a much slower pace than expected, with both headline and core inflation rising just 0.2 percent for the month. The year-over-year gain in headline CPI fell to three percent, in part because some of the super-sized price gains from the prior June have now fallen out of the yearly comparison. The one year gain in core CPI fell to a still-very high 4.8 percent from the prior month’s 5.3 percent.
There are some reasons to expect this to persist. The April and May reports included sizable increases in used car prices—something telegraphed by rises in wholesale used cars earlier in the year. Now the wholesale market is telling the opposite story: prices are coming down as a combination of larger inventories of new cars, tighter financing standards, and higher interest rates bring down demand. Used car prices fell 0.5 percent in June and are likely to keep falling over the next few months.
Used cars for sale at a dealership in Doylestown, PA, on Feb. 4, 2022. (AP Photo/Matt Rourke)
Another reason to believe the decline in inflation could persist is that June’s data indicated a broadening of disinflationary trends.
Michael Gapen of Bank of America points out that the share of categories of consumer products with three-month annualized inflation above five percent fell to 29 percent. Fed Chairman Jerome Powell’s favorite metric—three-month annualized inflation in core services excluding housing—decelerated.
The producer price index (PPI) also came in softer than expected. Headline and core PPI both came in at just 0.1 percent. So-called “core core”—which excludes trade services as well as food and fuel prices—was also just 0.1 percent for the month.
The category of “processed goods for intermediate demand” is a good indicator of cost pressures further up the supply chain. This looks at prices businesses pay for products they use in making final products sold to households, the government, and for export. Prices here were down 0.6 percent for the month. Excluding food and energy, core intermediate goods were down 0.4 percent, the first monthly decline since March’s -0.2 percent drop. For much of the year, core intermediate goods prices have been rising, so if this is the beginning of a trend of cost pressures easing, that would be welcome.
Goldilocks Wrapped in the Gown of Immaculate Disinflation
The reaction in markets was euphoria. There were rallies in almost everything from commodities, to emerging markets, to global bonds, to the S&P 500 as softer inflation in the context of a still-super tight labor market seemed to hold out the possibility that a “soft landing” and “immaculate disinflation” is once again a real possibility.
Bank of America’s Michael Hartnett described this as “Goldilocks schools us bears.”
“Goldilocks rules risk assets for now,” Hartnett wrote in a client note on Thursday night.
Hartnett remains bearish, however. His note warned that investors are piling so much money into stocks that valuations are in danger if inflation proves stickier than the June numbers imply and if hawkish central bankers keep raising rates.
He argues that this year’s disinflation will prove “transitory” and that rates will keep rising. The rate cuts expected by this week’s market bulls will not happen without a “very hard landing.”
Indeed, at the end of the week there seemed to be a little worry seeping into markets. The bond market sold-off after the University of Michigan reported a big surge in consumer sentiment. That made investors begin to worry that perhaps the porridge was “too hot” rather than “just right.”
Underlying Measures Were Mixed, and Waller Is Hawkish
Hartnett may have a point. The Federal Reserve Bank of Cleveland’s 16 percent trimmed-mean CPI came in at 0.2 percent for the second month in a row. We take that as a somewhat mixed message. It indicates that inflation has come down but may not be trending down. Similarly, median CPI came in a 0.4 percent for the fourth month in a row, suggesting no progress at all. To us, that indicates a heightened risk of a resurgence of inflation later this year.
As Fed Governor Christopher Waller reminded us in a speech Thursday night, all this has happened before.
“Yesterday, we received new data on consumer price index (CPI) inflation. After 5 consecutive monthly readings of core inflation of 0.4 percent or above, this rate dropped by half in June, to 0.2 percent. This is welcome news, but one data point does not make a trend. Inflation briefly slowed in the summer of 2021 before getting much worse, so I am going to need to see this improvement sustained before I am confident that inflation has decelerated,” Waller said.
Federal Reserve Governor Christopher Waller attends a Fed Listens event in Washington, DC, on Sept. 23, 2022. (Al Drago/Bloomberg via Getty Images)
Waller was very clear that he will support a hike at the July Fed meeting and believes that it is likely there will need to be another hike after that.
“I see two more 25-basis-point hikes in the target range over the four remaining meetings this year as necessary to keep inflation moving toward our target,” he said.
Perhaps the most interesting part of Waller’s speech was his pushback against the idea that the Fed might not have to do much more to raise rates because the effects of last year’s hikes are still moving through the economy with long lags. Instead, as his speech’s title put it, Waller thinks “big shocks move fast” and have already passed through to the economy. Further progress on inflation may very well require further tightening. He said:
What is the implication of this economic research? The effects of policy tightening last year are feeding through to market interest rates faster than typically thought because of announcement effects, and on top of this we have had policy rate changes that have been more dramatic and faster than in the past which most likely has led to a more rapid adjustment in the behavior of households and firms. These two points suggest that the effects of the large policy changes that we undertook last year should hit economic activity and inflation much faster than is typically predicted.
If one believes the bulk of the effects from last year’s tightening have passed through the economy already, then we can’t expect much more slowing of demand and inflation from that tightening. To me, this means that the policy tightening we have conducted this year has been appropriate and also that more policy tightening will be needed to bring inflation back to our 2 percent target. Pausing rate hikes now, because you are waiting for long and variable lags to arrive, may leave you standing on the platform waiting for a train that has already left the station.
The market remains skeptical of a second hike after the July meeting and has more or less excluded the notion of more hikes in the new year. We think a fair reading of Waller’s comments suggest that further hikes remain possible if the Fed’s earlier hikes are no longer having a disinflationary effect.
