Don’t Get Spooked by an Inflation Rebound

•    Annualized CPI growth could rise to 2.7% in October.
•    Fading easy comparisons could drive inflation even higher by year end.
•    Yet, after a brief rebound, CPI could be back to 2% by March 2025.

Prepare for a modest rebound in the consumer price index…

Over the last couple of years, headline inflation growth has experienced a steady move lower. Since the annualized data hit a peak of 9.1% in June 2022, the measure tumbled all the way back to 2.4% in September… 

The change means CPI is approaching pre-pandemic levels and almost back to the Federal Reserve’s 2% inflation target. But as you’ll notice on the right side of the above chart, the last 16 months haven’t been all smooth sailing. After hitting 3% in June 2023, price pressures shot back up to 3.7% before sliding decidedly lower once more.

Well, based on how the annualized data is calculated, we could be in for another inflation rebound over the next several months. That could get the stock-market bears crying foul amidst Federal Reserve rate cuts. But then after peaking in December, the measure could drop to 2% as soon as March of next year. That would support a steady rally in the S&P 500 Index.

But don’t take my word for it, let’s look at what the data’s telling us…

Inflation growth is measured in two ways… on a month-over-month and year-over-year basis. We watch the annualized number because they smooth out the wild swings associated with the monthly data. But we must also remember the yearly total is the last 12 monthly numbers added together.

As a result, it’s important to keep an eye on the monthly data that’s about to drop off… because we might be losing weak or strong comparisons from a year ago that could drive headline inflation higher or lower.

And, as luck would have it, just such an event is about to take place…

You see, October, November, and December 2023 are three of the weakest monthly numbers we’ve experienced in the last twelve. And January through April of this year were four of the strongest we’ve experienced. Take a look…

So, as we move forward, the weaker months will drop out of the total, pushing the yearly rate of growth higher. And as you’ll notice, it’s not until April that the rate of increases will start to ease once more.

Now, we want to find what the pace of monthly growth looks like moving forward. By observing the above chart, we get a good idea. We can add up the pace of growth from April through September and divide it by six. That tells us the average rate of growth is 0.17%.

But to understand whether the trend will continue, we can observe the prices received indexes from regional Fed manufacturing surveys. The data is compiled monthly by the Dallas, Kansas City, New York, and Philadelphia Feds. They ask manufacturers in their districts whether prices paid by customers for their goods rose, fell, or stayed the same. So, it’s akin to CPI, but it’s released two weeks earlier. And, because these districts represent around 25% of domestic economic output, we can get a sense of what’s happening on a national basis ahead of time…

In the above chart, you’ll see the combined number (blue line) and CPI (orange line). However, the combined number data goes through October while CPI is up to September. In October, my combined number fell to 6.3 compared to 8.3 in September. In fact, the reading has held in the range we’ve experienced over the last two years as annualized CPI has continued to fall.

So, now that we have confirmation inflation appears to be holding steady, let’s project what 0.17% monthly growth will look like going forward…

As you can see in the above table, annualized inflation could jump back up to 2.7% when the October data comes out next week. In fact, it could rise as high as 3.3% by December. That’s due to the high rates of inflation growth experienced in the fourth quarter of 2023. But then as the numbers ease in 2025, price pressures will ease once more. By March, CPI could be back to the central bank’s 2% target.

Yet note the change in the real rate of interest (effective federal funds rate minus CPI). Our central bank could introduce 100 basis points worth of rate cuts by next June and still have a real rate of 2%. That would still place downward pressure on inflation.

So, like I said at the start, don’t be surprised if the inflation conversation starts to feel uncomfortable over the next few months. Based on the numbers we looked at, the gains we’ve made in slowing inflation growth over the past two years could all seem for naught. But the rebound will be short lived. As the comparisons start easing, CPI could be sustainably below 2% by the middle of next year.

The change will support continued rate cuts by the Fed. That should help to stabilize domestic economic growth and underpin a steady rally in the S&P 500.