The Base Effect in CPI

Economic history is replete with incidents of hubris followed by lessons in humility. The latest CPI data showed y-o-y CPI is down to 3.0% in June 2023. The last time headline CPI had a three handle was 2 years and 3 months back in March of 2021. So a lot of folks have been asking “Why isn’t the Fed doing a victory parade flaunting the vanquished adversary of inflation on its monetary policy spears” ?

And the simple answer is : There is a good chance that inflation has bottomed and the Fed is far from done. Now, notice that I used the word chance and did not put a 100% probability to this event. Putting a 100% probability to any event in economics is foolhardy business. But there is a good chance we have not seen the end of inflation and the last of the Fed rate hikes.

The Base Effect

The chart below illustrates the underlying message better than any amount of words can.

Average monthly inflation in the 12 months to June 2022 was 0.7%. Hence it was an easier bar to cross on the way down for y-o-y CPI over the past 12 months. However, average monthly inflation during the 12 months to June 2023 has been 0.2%. That is a much tougher threshold to beat!

For headline CPI to come down below 3%, a number of factors need to come together. For instance, declining food prices, energy prices falling further from current levels, goods disinflation which includes new and used car prices and finally shelter coming down rapidly over the next 12 months. The next 2 months are especially hard to beat, given that m-o-m CPI had registered 0% and 0.2% in July and August 2022. Lets take a deeper look at shelter and used car prices.

Shelter Component in Inflation

The Fed is banking a lot on a rapid decline in shelter inflation. Owners equivalent rent of residence, which has a 25% weight in CPI, declined from a 0.5% to 0.4% in June 2023. That is still 4.8% on an annualized basis – which is not sufficient to bring headline inflation below 2%. The lagged effects between private measures of rent and the shelter component of CPI have been well documented by economists. See below chart. Past statistical analysis show a 12 month lag before current rent inflation starts reflecting in official CPI data. In other words, the shelter component of CPI will substantially trend down in 2H 2023. The issue though is that even now private rents are as high as 4% annualized.

Source: Zillow, BLS.

The latest ZORI read was +4.1% y-o-y rent inflation, which is not sufficient to bring headline CPI inflation below 2%.

Used Cars Price Inflation

On the other hand, used car prices are helping the case for disinflation.

The Manheim Used Vehicle Value Index has been, in my humble opinion, a good predictor of used car inflation in the CPI with a few months lag. See chart below. From this perspective, it is a blessing that wholesale used vehicle prices have been rapidly falling over the past 3 months of April, May and June. The latest data also shows wholesale used vehicle prices declined a further 1% in the first 2 weeks of July. We can expect the decline to reflect in the official CPI data over 2H 2023.

Source: Manheim, BLS

The Unprecedented Strength of the American Economy

Consensus Expectations for 1Q GDP growth were 1.8%. Instead the advance estimate from the Bureau of Economic Analysis showed US GDP grew at 2.4% in the first quarter. Does anything need to be said further?

Source: BEA

Here is an “as-concise-as-it-gets” summary of the US economy.

  • The US consumer is still resilient.
  • Bank lending, while undoubtedly slower, can hardly be described as collapsed.
  • The downturn in the US residential real estate sector has proved to be the shortest ever.
  • Core capital goods, which are a good indicator of business spending, are growing and far from recessionary levels.
  • New home sales have bottomed at the end of 2022 and are about 24% above the lows of 2022. New Home Builder confidence is in expansionary territory and builder stocks are at all-time highs.
  • Services PMIs are still in expansionary territory
  • M2, which was falling since mid 2022, has increased since Apr 2023
  • The consumer confidence index is on an upswing and future expectations index above levels that indicate a recession.
  • Initial jobless claims have moved back down over the past 6 months.
  • And finally, jobs are still being created at a 200K+ clip.

The FOMC which turned out to be a Non Event

Given the uncertainty around the inflation path forward and the surprisingly resilient US economy, it was little surprise that Chairman Powell wanted to keep his cards as close to his chest as possible at the latest FOMC press conference. It was probably the most uneventful FOMC meeting in recent monetary policy history. In fact, at one point during the Q&A, Chairman Powell actually said –

This is not an environment where we want to provide a lot of forward guidance.

Chairman Powell. July FOMC Press Conference

The S&P500 and the 2 year Treasury were mostly flat during Fed Day, except for a brief few minutes during the press conference Q&A. It seemed like that brief reaction was in response to Chair Powell stating that he expects inflation to come down to 2% only in 2025 – which we already know is the Fed view based on the June Summary of Economic Projections.


So, the above economic data is the reason why the Fed isn’t doing a victory lap yet.

A ton of experts say that Chairman Powell’s pre-dominant fear is that he doesn’t want to go down in history as the second Arthur Burns. I believe that to be true. However, paradoxically, I believe, deep down he wants to prove to the world that even though he was wrong on “transitory inflation”, he is right on “achieving a soft landing”. That sets the world up to the possibility of a greater mistake!

Happy investing!

Shashank Sawant

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