Wall Street May Be Underestimating Inflation
The consumer inflation report this week has the potential to upset the consensus view that the Federal Reserve will start cutting rates in the first quarter of this year.
The Department of Labor will release its report on the consumer price index (CPI) for December. Wall Street is expecting inflation to accelerate a little from the 0.1 percent monthly figure and 3.1 percent annual figure reported for November. The consensus forecast is for a 0.2 percent increase in the one-month CPI and 3.2 percent for 12-month CPI.
This is somewhat cooler than the Cleveland Fed’s nowcast of a 0.3 percent month-to-month and a 3.3 percent annual increase in CPI, but it is within the range of Wall Street’s forecasts. Bank of America’s analysts, for example, forecast a 0.3 percent increase for the monthly figure.
Seasonal Adjustment Chaos
One of the things that could cause an upside surprise is that the Labor Department’s seasonal adjustments appear to have fallen behind the real world discounting policies by merchants. As holiday shopping has migrated forward in the year, with a larger share occurring in September and October, businesses have competed for consumers’ dollars with early discounts. This has likely flattered the inflation numbers for the early fall, especially that downside surprise of just a 0.5 percent month-to-month increase in CPI in October.
Evidence that early discounting may have pushed down the monthly figures can be seen in the details of the September and October CPI reports. The index for goods excluding energy goods fell 0.4 percent in September and another 0.1 percent in October. Household furnishings and supplies were down in both months. Appliance prices fell 1.4 percent in September and 1.2 percent in October. Apparel prices fell 0.8 percent in September and then climbed just 0.1 percent in October. Jewelry prices were down 0.9 percent and then 0.4 percent. Toy prices fell in both months. Computer prices were up in September but dropped 0.8 percent in October.
When stores put things on sale during the traditional holiday shopping season that begins on Black Friday, the Labor Department’s economists make adjustments to the consumer-price index so that temporary, seasonal discounts do not show up as changes in the price level of the economy. Otherwise the CPI would show huge deflationary surges in December followed by inflation in the following months. Seasonal adjustments are meant to smooth out the regular ups-and-downs of discounting.
When the sales happen earlier—as they have been for the last few years—the discounts can look like disinflation. If the new seasonality lasts long enough, it will eventually be incorporated into the official seasonal adjustments. But this takes several years. It could take five years at a minimum, but probably more like eight to ten years of a consistent change in merchant pricing behavior.
Few analysts on Wall Street have shown any evidence that they are aware of this lag in seasonal adjustment. To the analyst crowd, October’s numbers were evidence of strong disinflation and even deflation in the prices of goods.
The payback for early discounting is less discounting in December. When the smaller discounts are run through the seasonal adjustments that expect larger discounts, the result may show prices unexpectedly increasing or holding steady.
The result could be inflation coming in hotter than expected in December on a month-to-month basis.
But Wall Street May Ignore an Upside Surprise
How will Wall Street react to an upside surprise in inflation? We began by saying that Thursday’s CPI report has the potential to upset the rate cut apple cart. But that is far from a certainty.
In recent months, the reaction has been much stronger to downside surprises than upside surprises. Investors are extremely attached to the conviction that inflation will continue to fall toward the Fed’s target without any more policy tightening. Indeed, they are convinced even lower rates will not stand in the way of disinflation. So, the reaction to an upside surprise may be quite muted—at least in the short term.
And they may be right when it comes to Fed policy. A hotter-than-expected December inflation figure is unlikely to move Fed officials from their conviction that monetary policy is restrictive and can be “normalized” because inflation is coming down. It would likely take several months of rising inflationary pressures, strong jobs numbers, and above-trend growth to convince the Fed that the December dovish pivot was premature.
