The Inflation Perfectionists

Subscribe to the?Notes on the Week Ahead newsletter ?to receive it directly in your inbox and access Market Insights on Amazon Alexa & Google Home.

The pandemic was my excuse to abandon piano lessons.?

It wasn’t that I wouldn’t practice or didn’t enjoy pounding away on the keyboard.?The problem was that my piano teacher, Tatiana, is a perfectionist.?She wanted me to get it exactly and precisely right and so I practiced the same piece over and over.?She would smile as I did my lessons but it was a strained and pathetic smile, as the masterpieces that she had loved from her youth were mangled, tortured and slowly murdered in a most grizzly fashion by yours truly.?Finally, I couldn’t do it to her anymore and I used the pandemic as a way out.

I will say that Tatiana had a right to her perfectionism.?She was, after all, the only victim of it.?The same cannot be said for the Fed and its quest for the perfect 2% inflation rate.??

The week ahead will be a busy one for investors, with earnings reports throughout the week, a GDP report on Thursday and inflation numbers on Friday in the form of the personal consumption deflators.?However, markets will be most focused on Wednesday’s Federal Reserve meeting.

Fed officials have heavily telegraphed their actions and, as of this morning, futures markets are pricing in a 94% shot of another 25 basis point rate hike, boosting the federal funds rate to a range of 5.25%-5.50%.?However, investors will closely scrutinize the language in the statement and at Chairman Powell’s press conference to assess where the Fed goes from here.

Most likely, the Fed will still convey a hawkish message.?In their statement, they may feel compelled to admit that inflation has fallen.?However, they are likely to warn of “additional policy firming” that may be appropriate to return inflation to 2 percent over time.?One key phrase to watch out for in the statement is whether the Fed expresses uncertainty about the extent of additional policy firming that may be appropriate, as they did at their June meeting, or extent to which additional policy firming may be appropriate, as they did at their May meeting.?A return to the May language would be interpreted as a dovish signal.

However, while the Fed has provided occasional dovish signals over the past year, they have generally become ever more strident in insisting they reach their 2% inflation goal.?This perfectionism is a little strange given how much inflation has already fallen, with the seasonally-adjusted year-over-year CPI inflation rate dropping from 8.9% in June 2022 to 3.1% a year later. It is also a little absurd – while high and unpredictable inflation is clearly an economic negative, once inflation is mild and steady, there is very little reason to believe that the economy operates more efficiently at 2% inflation than at 1% or 3%.?Most importantly, it is dangerous since the Federal Reserve cannot forecast how all aspects of the U.S. economy will react over time to a sudden hike in short-term rates to over 5% after nearly 15 years of close to 0% rates.

However, the economy and markets are now at the mercy of inflation perfectionists and so it is important to consider the path inflation could take to the Fed’s very precise goal.??

The Outlook for CPI

While the Fed’s official inflation target pertains to the headline personal consumption deflator, the most widely-reported U.S. inflation index is the consumer price index for all urban consumers, commonly known as CPI-U or CPI.?

In June 2022, seasonally-adjusted year-over-year CPI inflation hit a more than 40-year high of 8.9%.?Since then, it has declined for 12 straight months, falling to 3.1% by this June.?Going forward, a look at the major inflation components suggests it will move sideways for the rest of the year and then slowly down in 2024.?In particular:

• ??Food prices should be relatively steady, reflecting a decline in global food commodity prices since the early days of the Ukraine war, fewer supply-chain issues impacting grocery stores and an income squeeze on lower and middle-income households that is limiting demand.
• Energy prices should also be steady as rising U.S. petroleum and natural gas production offsets declines in output from OPEC and Russia and the global economy experiences only moderate economic growth.
• Core goods prices should be steady-to-down reflecting fewer supply chain issues and improved inventories.
• Core services inflation will remain high for a while due to a lagged decline in the growth of rents and owners’ equivalent rent as well as high inflation in transportation services reflecting prior spikes in new car prices.?Importantly, however, both of these areas of inflation have begun to fall from high levels.

Wage pressures have eased over the past 15 months, with the year-over-year gain in average hourly earnings for production workers dropping from 7.0% in March 2022 to 4.7% in June of 2023.?Despite this, cost pressures from higher wages will likely slow the inflation decline.?That being said, we expect year-over-year CPI inflation to drift down to 2.8% by December 2023 and 2.0% by December 2024.

The Outlook for PCE

As mentioned earlier, however, the Federal Reserve does not regard CPI as its primary inflation target.?Rather, as it reaffirms every January in its Statement on Longer-Run Goals and Monetary Policy Strategy, it is trying to achieve 2% inflation as measured by the annual change in the price index for personal consumption expenditures, more commonly known as the PCE deflator.?So where is that headed?

First, it should be noted that PCE inflation tends to be lower and steadier than inflation as measured by the CPI.?The very high inflation of the last two years amplified these differences and is probably not representative of where we go from here.?However, in the 20 years before the pandemic, the annual average PCE inflation rate was 1.85% compared to 2.17% for CPI – or 0.32% cooler.

So how is PCE inflation different from CPI inflation?

One part of the difference is due to the type of index used and revolves around the question of substitution effects.?In broad terms, the CPI index is a fixed-weighted index based on a basket of goods and services bought by consumers, with the weights assigned to particular goods and services once a year [1] based on survey data.?While this sounds reasonable, it tends to overstate inflation, since if the price of some item soars relative to something else, consumers will tend to substitute away from it.?If the price of beef surges, people will likely buy less beef and more chicken.?

The PCE deflator is a chain-weighted index, in which weights are based on an average of the old basket of goods and services, before prices changed, and a new basket, after prices changed.?Although this is harder to estimate with precision and can only be calculated with a slight lag, it is a better reflection of the true impact of inflation on consumer welfare.

It should also be noted that there are differences the scope of the CPI and PCE indices. In general, the CPI measures the out-of-pocket costs faced by consumers while the PCE deflator measures the change in the cost of goods and services consumed by households.?This makes medical care much more important in the PCE deflator because it includes medical expenses paid for by businesses (via health insurance) and by the government.?It also means that housing is proportionately less important in the PCE index than in the CPI.

However, even with these differences, and some variation in original source data, it is relatively straightforward to forecast PCE inflation once we know CPI inflation for a month.?We expect the June PCE data, due out on Friday, will show seasonally-adjusted increases of 0.1% month-over-month and 3.0% year-over-year, compared to 0.2% and 3.1% in the CPI data released on July 12th.?Looking further out, we expect PCE inflation to drift down to 2.7% year-over-year by December of this year, fall below the Fed’s 2% target by next April, and reach 1.7% year-over-year by December of 2024.

The Path to Inflation Perfection

At his press conference on Wednesday, Chairman Powell may refer to some other measures of inflation including core PCE and core PCE services ex housing.?However, we expect both of these numbers to also show a moderating trend.?Going forward, while there is plenty of uncertainty about whether or when the economy will enter recession, the economy does seem headed to the 2% inflation target to which the Fed aspires.

We believe that the Fed will probably recognize this in the months to come and, despite a dot plot that shows two more rate hikes this year (including this week’s), on balance we think this week’s increase may end up being the final one for this cycle.

That being said, the Fed is unlikely to cut rates this year unless the economy falls into a significant recession.?For 2024, the Fed’s dot plot currently shows the federal funds rate falling by 1%.?However, this pace of rate cuts may understate Fed easing in 2024.?First, as noted earlier, the economy may well achieve 2% consumption deflator inflation by next spring.?Second, as that happens, the economy may get into trouble.

Perfectionism, when targeting inflation, is a luxury.?If the economy slides into recession or sees a major financial market slump or is hit by some big exogenous shock, the Fed may change its mind and decide that close enough is good enough on inflation.?

Either way, if the Federal Reserve raises rates as expected this week, odds are they will be in the middle of cutting them a year from now and investors should make sure that they are positioned for not just lower inflation but also lower interest rates in 2024.?

[1] Prior to January 2023, the weights were revised only once every two years.?The new procedure should have the impact of slightly reducing CPI inflation both in absolute terms and relative to PCE inflation going forward.

For more insights, listen to the?Insights Now podcast .

Disclaimers

Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. The views and strategies described may not be suitable for all investors. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

Content is intended for institutional/wholesale/professional clients and qualified investors only (not for retail investors) as defined by local laws and regulations. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide (collectively “JPM”).

Opinions and comments may not reflect those of J.P. Morgan or its affiliates. Content is intended for US audience only, and should not be considered a recommendation or endorsement by JPM for any product, service or strategy specific to any individual investor’s needs. JPM is not responsible for third-party posted content. "Likes", "Favorites", shares, similar functionality or content appearing on third party websites should not be considered an endorsement of JPM products or services.”).