Slicing & Dicing Inflation

This is an excerpt from the October 16, 2023 Yardeni Research Morning Briefing

Most economists, including Debbie and me, believe that if the data don’t support our forecasts, then there must be something wrong with the data and that they will be revised to show we were right after all. Most economists, including yours truly, also often dismiss components of headline indicators that don’t support our story and look to the remaining “core” indicators for conformity to our outlook and therefore confirmation of it.

This slicing-and-dicing approach to the major economic indicators is usually what happens when the monthly employment report is released. If the seasonally adjusted data don’t support one’s narrative, the thinking goes, perhaps the data on a not seasonally adjusted basis will. Or perhaps the revisions to the prior months’ data will point in the “right” direction and therefore be what to highlight. If the payroll measure of employment isn’t as friendly as the household measure, focus on the household one.

Another major economic indicator that is invariably sliced and diced by the brotherhood and sisterhood of economists is the CPI. September’s number was released along with all its components last week on Thursday. Some economists (such as us) claimed that it confirmed that inflation is still moderating and is turning out to be relatively transitory. Others looked at the report and concluded that inflation is stalling at a pace well above the Fed’s 2.0% inflation target. A few economists found evidence that inflation may be accelerating again, so it remains a persistent problem.

So who is right? We all are right all the time because there’s plenty of data to support all of our stories. Nonconforming data are dismissed as preliminary estimates that undoubtedly will be revised or simply are flawed. Future revisions no doubt will show that we are on the right track after all; if not, different data do so. We may not all be Keynesians or monetarists, but we are all prescient based on the data we choose to support our outlook!

Now let’s slice and dice the latest CPI and see what’s left:

(1) Ignore the headline. Pay no attention to the headline inflation rate. That was one of the messages in the speech delivered by Fed Chair Jerome Powell at Jackson Hole on August 25. From the get-go, he said that “food and energy prices are influenced by global factors that remain volatile and can provide a misleading signal of where inflation is headed.” So he focused his analysis on the core inflation rate, i.e., the headline rate less energy and food. Of course, this has been the Fed’s approach for many years.

The Fed’s preferred measure of inflation has been the core PCED, which closely tracks the core CPI (Fig. 1). The latter tends to exceed the former. For today, we will focus on the CPI through September since the PCED’s September reading won’t be out until near the end of the month.

The headline CPI inflation rate was 3.7% y/y through September (Fig. 2). The core rate for the CPI was higher at 4.1%. Both are down from their 2022 peaks of 9.1% and 6.6%, respectively. But both remain well above the Fed’s 2.0% target.

(2) Taking out shelter. Before we go any further, here’s our punch line: The headline and core CPI inflation rates excluding shelter were both 2.0% y/y during September (Fig. 3). So to the question of when we’re going to get to the Fed’s inflation target, the answer is that we’re there now excluding shelter, at least based on the CPI measure!

Rent of shelter accounts for a whopping 34.7% and 43.6% of the headline and core CPI measures. Its inflation rate jumped from a low of 1.5% during February 2021 to a peak of 8.2% during March 2023 (Fig. 4). It was down in September but only to 7.2%.

In his speech, Powell observed: “Because leases turn over slowly, it takes time for a decline in market rent growth to work its way into the overall inflation measure. The market rent slowdown has only recently begun to show through to that measure. The slowing growth in rents for new leases over roughly the past year can be thought of as ‘in the pipeline’ and will affect measured housing services inflation over the coming year.”

Also, Powell acknowledged in his speech that “market rent” inflation (i.e., for new leases) has declined “steadily” this year. The Zillow rent index was down to 3.2% y/y during September. Using that reading rather than the CPI’s rent of shelter reading of 7.2%, Debbie found that the headline CPI is up just 2.3% versus 3.7% for the actual headline CPI!

Based on our analysis so far, the latest bout of inflation is turning out to be transitory rather than persistent after all, in our opinion. The Fed might achieve its 2.0% target for the core PCED inflation rate well ahead of schedule, i.e., in 2024 rather than 2025.

(3) Goods inflation is good. In his speech, Powell implied that core goods inflation undoubtedly has turned out to be transitory after all. He said: “Core goods inflation has fallen sharply, particularly for durable goods, as both tighter monetary policy and the slow unwinding of supply and demand dislocations are bringing it down.”

We’ve previously explained that consumers’ post-lockdown buying binge was focused on goods because services were still hampered by social distancing restrictions. That caused goods inflation to spike from around zero in the summer of 2020 to 14.0% in 2022 (Fig. 5). During September, goods inflation was down to 1.4%, with durable goods down 2.2% and nondurable goods up 3.2%. Core goods were unchanged in September from a year ago (Fig. 6).

(4) Supercore inflation is persistent. In his speech, Powell said: To understand the factors that will likely drive further progress [on lowering inflation], it is useful to separately examine the three broad components of core PCE inflation—inflation for goods, for housing services, and for all other services, sometimes referred to as nonhousing services.” That last category has also come to be known as the “supercore” inflation rate. It has been sticky, having been stuck around 4.5%-5.0% since October 2021 (Fig. 7). However, the CPI services less housing inflation rate was down to 2.8% in September from last year’s peak of 8.2%.

(5) Health insurance is wild. It is widely recognized that the CPI’s health insurance component is very volatile and based on a very questionable measurement technique (Fig. 8). Far more sensible is the PCED’s measure of health insurance, which recently has been relatively stable and in the low single digits on a y/y basis, while the CPI measure has been bouncing around between positive and negative double-digit y/y percent changes. The latter was down 37.3% y/y during September and is now expected to swing back into positive territory for the next few months.

We all know this and will adjust for this distortion. In any event, it has a tiny weight of 0.545% of the CPI.

(6) Auto prices could accelerate. Contributing to the volatility and transitory nature of inflation since the pandemic have been new and used car prices. Supply-chain disruptions disrupted the supply of new cars in 2020 through the first half of 2022, sending new car prices soaring. As these problems abated, the inflation rate of new car prices plummeted (Fig. 9).

Used car prices soared even more than new cars prices during the pandemic, and the former plunged more than the latter afterwards (Fig. 10). Now the concern is that the UAW strike will cause a shortage of new auto inventories that once again will boost new and used auto prices.

(7) Bottom line. They say that the devil is in the details. That may very well be true about the outlook for inflation. However, inflation is usually defined as a general and relatively broad increase in prices. In any one month, a few of the CPI’s components might account for much of the increase or decrease that month. It’s the underlying trend that matters. That’s what we look to most for either confirmation of our outlook or the need to change it. The latest data confirm for us that our narrative remains on track: Inflation is continuing to moderate.

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