The major market moving event last week (ended November 13) was Wednesday’s CPI release showing a three-decade high level of inflation (6.2% Y/Y; 0.9% M/M). The data surprised to the upside, especially after Tuesday’s rather benign PPI release. The core metric, which excludes food and energy, increased by 0.4% M/M and 4.6% Y/Y. Excluding rent and auto prices, the core (which already excludes food and energy) rose 0.2% (not very comforting for consumers who pay rent, eat, and drive).
The biggest culprit was the increase of 6.1% M/M in the price of gasoline in October. Because most of the adult population is sensitive to prices at the pump, the price of gas has a lot to do with consumer views on inflation. And these views have a large influence on Fed policy and interest rates. The one-year consumer view of inflation has now risen to the 4% level; a breakout from here is likely to elicit a Fed rate hike response. Longer-term, however, the consumer’s outlook for inflation remains somewhat subdued (near the 3% level).
Goods, Services and Poor Policy
The chart at the top shows an index of consumption expenditures broken down between goods and services with the index starting in 2012 at 100 for each. The chart shows a dramatic movement away from goods and toward services through the ensuing eight years when the services index grew +2.5 index points while goods declined by more than -6. Then came COVID and everything reversed. The goods index rapidly increased by +15 index points while services fell -7.5 (remember, the “non-essential” service economy was shuttered by government fiat in early 2020). Reopening has reduced the 22.5 index point gap to +7.5 index points, still in favor of goods but a far cry from the pre-pandemic +9 index point gap in favor of services.
As we have discussed in prior blogs, we are of the view that much of today’s inflation is due to government policies:
- The shut-downs, distancing requirements, and vaccine mandates, have caused supply-chain issues;
- As discussed above, the service sector shut-downs also caused a huge jump in the demand for goods (the back-up at CA’s ports);
- At the same time, the federal government sent helicopter money to most U.S. households and implemented generous and long-lasting unemployment benefits which both increased demand for goods and, to this day, have impacted labor supply;
- Basic economics says when reduction in supply is met with rising demand (due to the shift from services to goods and to free money), prices go up.
Looking at the services sector alone, prices rose 0.6% M/M in October and by 3.6% Y/Y. Elevated – yes, but much more well-behaved than the prices of many consumer goods. As noted in the chart, there has been a pivot back toward services now that the economy has been allowed to reopen. If this continues, the supply chain issues will begin to heal (although this may take a few quarters).
Energy & Rents
Going forward, we do not expect significant reductions in energy (gasoline) prices, as much of this issue has to do with policies directed at green energy. Because of the infancy of the green energy industry and the high implementation costs, a rise in the price of fossil fuels is necessary to spur investment in green technologies.
Rents are an inflation area that is also likely to remain elevated. They make up 30% of the CPI. Remember that government policy put moratoriums on evictions and foreclosures, and landlords had significant rent collection issues for a year. Now that the moratoriums have ended, they are demanding back-rent, and are raising rent to make up for a year of significantly reduced cash flow.
A good portion of the rent calculation in the CPI is a number that is imputed (not collected directly) by government statisticians called Owners’ Equivalent Rent (OER). Theoretically, OER represents the rental value of an owner-occupied home. As has been widely reported, the data don’t seem to be realistic, and appear, until recently, to have been holding down the CPI increases. But, no longer. OER rose 0.4% in October, a repeat of September’s rise. This is nearly a 5% annual rate of increase. And, it looks like it will get worse and pose a headache for policymakers in the near-term. Our view is that this is a short-term issue because there has been a significant rise in multi-family housing starts over the past several months, and we also note that single-family homes are being increasingly purchased by REITs and hedge-funds with the intent to rent. The increase in supply, we believe, will eventually quell what we foresee as a few quarters of rising rents.
From an unemployment standpoint, the labor markets have continued to heal, trending toward their pre-pandemic “norms.” Continuing Unemployment Claims (CCs), at 2.57 million (week of Oct. 23) are now approaching the 2.11 pre-pandemic level (compare the right-hand and left-hand sides of the chart).
We did have a set-back in Initial Unemployment Claims (ICs) the week of Nov. 6, up +13K. Our Opt-Out/Opt-In state-by-state data shows the following anomaly for the week of Oct. 30:
- Opt-Out state unemployment continued to fall, now down -62.2% from its May 15 base level, and down -2.6 percentage points from the prior week (Oct. 23). But Opt-In states actually lost ground, rising +1.9 percentage points in the latest data week (Oct. 30), led by big increases in ICs in CA, IL and MI. We don’t have supporting data as to why this occurred, but speculate that some of the issue could revolve around the well-publicized public-sector layoffs for non-compliance with vaccine mandates.
Besides the rapid rise in gasoline prices, which is usually a harbinger of an upcoming slump in consumption, other data continue to warn of economic slowing:
- The October NY Fed Survey of Consumer Expectations showed a rise in the probability of debt delinquency to 11.2% of the sample vs. 9.9% in September’s survey.
- China’s economy continues to weaken due to deleveraging taking place in their residential sector and a continuation of energy issues for large power consuming industries.
- As we pointed out in last week’s blog, the Baltic Dry Index is down more than 50% from its early October peak. This is an index of shipments of bulk materials (no containers) (e.g., iron ore). While this is most likely a function of a slowing China, it still has worldwide business and inflation implications.
- The University of Michigan’s Consumer Sentiment Index, historically a good leading indicator of U.S. consumption, continued its plunge in November. The preliminary reading fell to 66.8 (vs. 71.1 in Oct.). As seen from the chart, the last time the reading was this low was during the Great Recession. We suspect that much of the lost confidence derives from the rapid rise in gasoline prices and the daily inflation banter from the financial media.
Much of the inflation spike has been caused by a combination of poor government policies and supply constraints. The Fed has no policy tools to deal with supply issues; it knows that (Chairman Powell even said so), and therefore wants to wait for supply issues to ease. So far, it has resisted market pressures, in its view, to prematurely begin the rate tightening process.
Energy (gasoline) inflation is partly due to supply issues, but some of it has to do with long-term policies regarding green energy. The price of gasoline in particular has caused consumer consternation and is likely a major cause of falling consumer sentiment. Rising rents are now also having an impact.
Interest rates fell after the Fed’s September meetings produced a more dovish Fed outlook, but they spiked back up last week (Nov. 13) with the CPI reading, as markets believe the Fed will have little choice but to start rate hikes early if the elevated inflation readings continue.
In our view, the fall in consumer sentiment, rising gasoline and rent costs, and other incoming data foretells of a slowing economy. If this occurs with elevated inflation numbers, the Fed will be caught between a rock and a hard place, and it is under such circumstances that policy errors occur.
(Joshua Barone contributed to this blog.)