The Big Idea

The pattern of inflation lulls

| July 21, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The June CPI reignited market optimism that inflation is on the cusp of rolling over persistently. I am more skeptical, both because of the composition of the slowdown in the June figures—mostly attributable to a few typically volatile categories—and because there is a history of false dawns over the past two years when core inflation briefly slowed only to reaccelerate again. A look back at recent episodes of a cooler core sheds some light on whether the June moderation is different.

Summer of 2021: “Transitory”

The core CPI had been languishing before to the pandemic at or just above 2%. After an initial wave of price cuts in the first months of the pandemic followed by a rebound when the economy initially reopened, core inflation settled into a slow upward path in late 2020 and early 2021. In the six months through February 2021, the core CPI registered two monthly gains of 0.2%’s, three gains of 0.1% and a flat reading. Then, suddenly, core inflation took off in the spring of 2021. This was mainly a function of economic activity more fully normalizing after pandemic-related restrictions. The core CPI surged by 0.8% in April, 0.7% in May and 0.7% in June. However, nearly all the acceleration reflected a jump in airfares and hotel rates, as the demand for travel returned, and in apparel and new and used vehicle prices, due to supply chain issues, especially in the motor vehicle sector. The contribution to the core CPI of the Fearsome Five—the five most volatile line items in the core: apparel, new and used vehicles, hotel rates, and airfares—accounted for all of the acceleration. In fact, the core CPI advance excluding the Fearsome Five was actually smaller in the April-to-June period than it had been in the prior three months.

Infamously, Fed officials described this spike in core inflation as “transitory.” Their contention was that these volatile categories would normalize and then inflation would quickly settle back to 2%.

The “transitory” view briefly looked accurate, as the core CPI dropped to a gain of 0.3% in July, 0.2% in August and 0.3% in September. This was the first lull in underlying inflation. As policymakers had suggested, the volatile categories settled back. The contribution of the Fearsome Five to the core CPI went from 0.6 percentage points per month on average in April, May, and June, to zero on average in the next three months. In particular, airfares sank by a cumulative 16% and used vehicle prices fell in all three months.

What Fed officials missed, however, was that while the aggregate core gauge was relatively benign, price hikes were accelerating outside of the Fearsome Five as the economy overheated. The rest of the core CPI contributed an average of 24 bp to the core increase from July to September, up from 14 bp in the prior three months. This was the time when shelter costs began to pick up noticeably. Household furnishings and operations also began to surge. Then, late in 2021, used vehicle prices and airfares rebounded sharply, even as the rest of the core CPI continued to accelerate. The core CPI jumped by 0.7% in October and remained high well into 2022.

Episode 2: Hope springs eternal

The Fed finally began to hike in March 2022. The very next CPI report, for March 2022 (released in April), showed the core CPI cooling from 0.5% in February to 0.3% in March. Talk about a quick impact of Fed action! I am kidding, of course. Used vehicle prices were the main culprit, diving by 3.6%, but rent also decelerated by a tenth and telephone services prices fell by 0.6%.

This slowdown in core inflation proved fleeting. Used vehicle prices fell again in April but only by 0.7%. Meanwhile, rent reaccelerated, hotel rates and airfares surged again, and services inflation had broadly begun to take off by then. As a result, the core CPI heated up to a 0.5% advance in April and only accelerated further from there, eventually setting the stage for the FOMC to step up the size of its rate hikes to 75 bp.

Episode 3: Summer respite

After back-to-back 0.6% jumps in May and June, the core CPI moderated to a 0.3% gain in July. Hotel rates and airfares fell sharply and used vehicle prices receded somewhat. The Fearsome Five contributed -10 bp to the core CPI on the month. In addition, medical care services and tuition moderated on the month.

The July slowdown turned out to be nothing more than noise. In August and in September, the core CPI increased by 0.6%. These outsized monthly advances were especially disturbing as they occurred without the benefit of much help from the Fearsome Five. In fact, the non-Fearsome Five component of the core CPI contributed nearly the full amount of the increase in both months. By this time, shelter costs were raging (up 0.7% in August and up 0.8 in September), household furnishings and operations costs were rising rapidly, and motor vehicle insurance rates were surging.

Episode 4: Health insurance feint

As I discussed in a recent note, the Bureau of Labor Statistics approach to estimating health insurance prices is quirky and has over the past two years led to outsized moves. For the 12 months ending September 2022, the expansion of profit margins for insurance carriers in 2020 led to big monthly rises for this category, and then the normalization in margins in 2021 led to a big negative swing starting in October 2022. These big negative readings will continue through September. The roughly 4% monthly declines that began in October have contributed about -3 bp to core CPI each month, which is pretty incredible for a category that accounts for less than 1% of the core index.

In addition to the health insurance swing, a number of categories softened in October and November. The Fearsome Five was close to flat in both months (not so different from the prior months), driven by falling used vehicle prices. In addition, household furnishings and operations prices went from substantial gains to marginal increases—up 0.2% and 0.1%, respectively—and medical care services aside from health insurance were also soft, with hospital services falling and physicians’ services flat. The result was back-to-back 0.3% monthly rises, which led many to conclude that the trend in core inflation had downshifted sharply.

Once again, these hopes proved premature. The core CPI reaccelerated by 0.4% in December and increased by that much or more every month through May. The Fearsome Five continued to make slight negative contributions in December and January, as used vehicle prices and airfares remained on a downtrend. However, shelter costs stayed on a steep upward path and the non-Fearsome Five aggregate contributed over 0.4 percentage points in December, January, and February.

Shelter costs finally began to cool a bit in March, but at that point, used vehicle prices rebounded and motor vehicle insurance accelerated further. It was in the spring of this year that Fed officials became increasingly frustrated with the lack of progress in underlying inflation, which ultimately led to the surprisingly hawkish dot projections released in June.

Episode 5: Could this one be real?

The June CPI shocked market participants, as core inflation slowed to a 0.2% advance, the best result since February 2021. This time, the moderation will surely stick, right? The composition does not give me great hope. The Fearsome Five contributed a negative 10 bp to the core CPI, the largest drag since April and May 2020. Used motor vehicle prices swung from a 4.4% jump to a 0.5% decline. In addition, hotel rates sank by 2.3% and airfares plunged by over 8%.

The rest of the core CPI also cooled, contributing 26 bp, the smallest figure since 2021. Some of this reflects a sustained moderation in inflation pressures. Shelter costs have cooled noticeably since peaking early this year, and household furnishings and operations have posted back-to-back declines. However, there were also a few quirks, including a 1.2% drop in telephone services prices, a reading unlikely to be sustained.

The good news is that over the next three months, there should be two reliable sources of disinflation. Used vehicle prices are likely to fall for the next few months and at a faster rate than in June. In addition, the health insurance drag explained above will extend through September. These forces may limit the core CPI over the next three months.

Nonetheless, I look for hotel and airfares to firm this summer, reflecting red-hot demand for travel. In addition, shelter costs may not cool by as much as some had hoped, as home prices and rents have turned higher again in recent months. In any case, I expect the core CPI to advance by 0.3% per month over the next few months, but excluding used vehicle prices and health insurance, the underlying run rate appears to be closer to 0.4% per month, double what the FOMC is targeting. Another gain of 0.2% in July would ignite victory celebrations, but the composition matters. If the core CPI rises by 0.2% because of a massive drop in used vehicle prices, it would be less meaningful than a broad-based easing of price pressures.

In any case, as several Fed officials noted after the June CPI release, one month does not make a trend. Even two or three are less than definitive if they are driven by easily identifiable outliers. I would not be shocked if core inflation looks benign again in July but then reaccelerates later this year, when used vehicle prices level off and the health insurance category shifts in October.

Stephen Stanley
1 (203) 428-2556

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