Inflation Melts: The Evidence and Implications


The CPI for December was released on January 12e (-0.1% M/M; +6.5% Y/Y). It turned out to be inflation transient after all, the time frame was 18 months. Supply chains are back to normal and we are seeing signs of falling prices everywhere we look. The ISM survey of prices paid in the manufacturing sector (39.4 December vs. 43.0 November) is approaching the lows reached during the Covid lockdowns in April 2020, and they are significantly below pre-Covid years such as shown in the graph above. Clearly deflationary.

In the December CPI squeeze (-0.1%), housing costs (mainly rent), which make up about 30% of the CPI, rose +0.8%. We know that the BLS uses outdated methods in measuring rents, and we know that rents have been falling in real time. BLS rent data is about nine months behind reality, as evidenced by the CPI rent index’s close fit to the New Tenant Repeat Rent Index nine months ahead (see chart above). If this close relationship continues, the CPI Rent Index is at or near its peak. So future CPI releases won’t be blown up by the delays in BLS’s current methodology. (The CPI rent index still won’t reflect reality, but at least for a while, the downward pressure on rents will be acknowledged.)

The math says that if rents increase by +0.8% in this calculation, given the weight of 30% in the CPI calculation, to arrive at the overall figure of -0.1%, the net of all other prices combined had to fall by almost -0.5%. That’s real deflation!

Other inflation data

Other data confirm our deflation hypothesis. The ISM survey shows order backlogs near the lows of the 2020 lockdown (left side of the chart) with supplier delivery delays significantly below those of the lockdown and pre-lockdown period (right side of the chart). chart).

Continuing this line of thought, the left side of the chart below shows the steady downward trend in new orders, while the right side shows the current collapse in used car prices (i.e., the original poster child for the current wave of inflation).

In recent months, we have commented on the decline in prices in the existing housing sector. The following chart shows that the percentage of homes selling above asking price has fallen to near-normal levels, another sign of easing price pressure. We believe this data point will fall significantly below the long-term average of 20% in the coming months.

Over the past six months, rents have fallen in once-hot markets: -3% in Las Vegas, -2% in Phoenix and -1% in Tampa. Part of the reason is the 400,000 new apartments that will hit the market by 2022. As 2023 is on track to produce more than 500,000 new units (see chart below), rents have a considerable distance to fall, and that will play a role in steering monetary policy in the second half of this year .

Where is inflation going?

We did a thought experiment to calculate what the Y/Y inflation will be in the coming months at different monthly percentage changes in the CPI.

The table shows two such results: one result if monthly inflation is 0% each month, and another result if it is -0.1%. Now we think that as the rental component catches up to reality, disinflation will be below -0.1%. But even with these conservative assumptions, the table shows that by the May/June period, inflation will have melted away and will be at or below the Fed’s target of 2%. That’s really good news, and it probably means that interest rates are starting to fall.

Bonds and stocks

The chart shows a 49-year chart using the Bloomberg Treasury Total Return Index plotted against the performance of the S&P 500 for the same year. The upper right quadrant contains the data points where both stocks and bonds delivered positive returns. This quadrant contains almost 70% of the years (34 of them).

The upper left quadrant shows years when stock returns were negative, but bond returns were positive (9 such years). There are six of the 49 years where bonds have had negative returns while stocks have been positive (bottom right quadrant). And then there’s the single lone dot in the bottom left quadrant that marks the year when both stocks and bonds had negative returns (both double digits). That dot represents last year (2022) and appears to be anomalous. In the 14 years when stocks or bonds had a negative return (lower right and upper left quadrants), the other had a positive return. 2022 is clearly an outlier.

Blame the Fed! The data in the scatter chart above spans the 1980s, when the Fed, led by Paul Volcker, raised interest rates into the teens to combat inflation that had become endemic in the 1980s. In that period, there were no years in which both stock and bond returns were negative.

Final thoughts

It was not that long ago (2010-2019) that the Fed was unable to raise the inflation rate to its long-term target of 2%. That’s because demographics and technology have brought us into a deflationary world. It was the break in the supply chains that caused the current wave of inflation, and indeed that part of the inflation was transient! But the Fed itself exacerbated that initial supply inflation by cashing in on the federal cash giveaways in 2020 and 2021. As we’ve noted in previous blogs, monetary aggregate growth was high double digits during those years.

Compare that to today – the fastest rise in interest rates since Volcker, and monetary aggregates shrinking at the same time. (We should point out that Volcker started cutting rates at the first sign of economic weakness. He didn’t wait for Y/Y inflation to fall to a predetermined acceptable level.)

In the closing minutes, the Fed admitted that their new “transparency” (ie signaling to markets where the FOMC predicts rates will be) is having issues as we approach the end of the rate hike cycle. This is due to the fact that sometime this year the financial markets are beginning to anticipate a move towards easing and the markets are moving in that direction, against the wishes of the Fed. Since the start of the new year, starting Friday, January 13, the 10 Yr. Treasury yields have melted from 3.88% to 3.51% (-37 basis points), while the 2 Yr. fell from 4.42% to 4.24% (18 basis points). Both are big moves in a short period of time. Even at this early stage of the new year, we think it’s safe to say that the 2023 dot won’t be in the lower left quadrant of the chart above. Yes, the yield curve is still inverted (short-term rates higher than long-term; a signal of recession), but markets now know that the Fed’s current extremely aggressive stance is just a facade to prevent markets from cutting rates before the Fed judges fit. So even after just two weeks into the new year, we think it’s safe to say that the 2023 dot in the chart above won’t be in the lower left quadrant. As we concluded in our last few blogs: “BAAA” (say it out loud!) (Bonds are an alternative).

(Joshua Barone contributed to this blog)