The Big Idea

Troubling September inflation result

| October 20, 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. This material does not constitute research.

Fed officials have taken great cheer from the slowdown in core inflation over the summer.  However, after back-to-back 0.2% advances in June and July, the core CPI accelerated to a 0.3% rise in August and then repeated that performance in September.  Moreover, the details of the September CPI report were, if anything, more troubling than the headline print.

How the Fed sees inflation

Chair Powell laid out a charitable view of recent developments for core inflation on October 19.  He noted that both 3- and 6-month annualized rates of core inflation are running below 3%.  He did acknowledge that the September CPI figures were “somewhat less encouraging.”

Powell’s assessment may be a tad overly upbeat, even on its face.  Through September, the core CPI was running at a 3.1% annualized pace over the past three months and at a 3.6% annualized pace over the past six months.  Including my projection of a 0.3% monthly advance in September, the corresponding 3-month and 6-month annualized figures for the core PCE deflator are likely to be almost exactly 3% for both.

It is also noteworthy that the core inflation figures over the last few months have been flattered by sharp declines in a few highly volatile categories.  To start, the back-to-back “low” 0.2% core CPI readings in June and July were driven by monthly drops of over 8% for airfares in both months.  In addition, used vehicle prices slid in each of the past four months.

Dissecting the September core CPI results

I was away the week of the CPI report earlier this month, so I was not able to offer a detailed analysis in real time.  Given how central the inflation outlook has been in shifting the Fed’s thinking, it seemed appropriate to circle back and walk through some of those details and then put the September results in context.

The core CPI reading for September rose by 0.3%, 0.32% unrounded, a couple of basis points higher than my projection.  The composition, however, was troubling.

To start, for the fourth month in a row, the grouping that I call the Fearsome Five, the five historically most volatile components of the core gauge, on balance subtracted from the core advance.  In September, these five categories—new vehicles, used vehicles, apparel, hotel rates, and airfares—contributed -3 bp to the core.  Hotel rates rebounded sharply in September, rising by 4.2%, unwinding most of the cumulative drop seen in June, July and August; much of this is likely statistical noise.  Airfares and new vehicle prices increased modestly.  However, apparel prices sank by 0.8%, the largest monthly fall since May 2020, and used vehicle prices dropped by 2.5%.

For what it’s worth, my guess is that the Fearsome Five will contribute negatively yet again in October, as hotel rates may fall back and used vehicle prices likely continued to sag, more than offsetting a probable rebound in seasonally adjusted apparel prices and firm new vehicle prices , the latter reflecting the modest supply constraint created by the UAW strike.

More importantly, the rest of the core CPI has been accelerating in recent months.  After bottoming out with a 0.26 percentage point contribution to the core CPI in June, this aggregate’s contribution picked up to 28 bp in July, 31 bp in August and 35 bp in September.  The September reading was the largest monthly increase for the ex-Fearsome Five grouping since February.

Delving into the details, the most troubling development in September was a reacceleration in shelter costs.  Rent was steady in September at gain of 0.5%, but the far-larger owners’ equivalent rent category went from a gain of 0.4% in August to a gain of 0.6% in September.

Many economists and a number of Fed officials continue to put forward a narrative that there is a significant lagged impact of the fall in home prices to shelter costs.  However, that narrative is starting to feel a bit long in the tooth.  As it turns out, home prices only fell for eight months according to the S&P Case-Shiller CoreLogic 20-city index and for just two months according to the FHFA purchase index.  Since early this year, home prices have returned to a rapid pace of increase.  Similarly, the Zillow rent index slipped modestly for three months in late 2022 and returned to hefty monthly gains by early this year.  So, if the historical experience of roughly a 1-year lag between home price and rent indices to the CPI shelter costs holds, then the period of decelerating shelter costs is probably about three or four months from coming to an end.  Year-to-date, the Zillow index is running at roughly a 4.5% annualized pace, and home prices have been rising much faster than that.  So, I am skeptical that shelter costs are going to decelerate much further for the rest of the year, and I am penciling in gain of 0.5% for both rent and OER as a placeholder for October. I also expect to see still-elevated readings in 2024, and I would not be shocked to see a reacceleration.

Another important technical point is that the quirky health care insurance line item is about to flip.  The monthly readings reflect a once-a-year assessment of health insurers’ margins from the prior year that covers the October-to-September period.  During Covid, when people avoided going for treatment, health insurers’ margins temporarily spiked, which the Bureau of Labor Statistics (BLS) counted as a big price increase.  When margins normalized in 2021, the BLS recorded a sharp drop in “prices,” which led to a noticeable drag from the health insurance line item in the CPI for the 12 months from October 2022 through September 2023, which was worth about -3 bp a month for the core CPI.  That drag likely will disappear beginning next month.  Importantly, this dynamic does not affect the core PCE deflator, which has a different methodology for measuring health insurance prices; it uses the PPI gauge instead.

In any case, Chair Powell and other Fed officials have emphasized the core services ex-housing component as the key measure for gauging whether inflation is moving back toward 2% on an underlying basis.  Unfortunately, that index for the CPI went from flat in June to a gain of 0.2% in July to a gain of 0.4% in August to a gain of 0.6% in September.  The corresponding monthly readings for the PCE deflator have been quite different but on balance still worked out to a 3.4% annualized pace in the three months through August.

Conceptually, the way that policymakers have carved up the core inflation measures into three pieces—core goods, housing, and core services ex-housing—makes sense in understanding the broad trends, as the drivers of the three components are quite different.  However, from a monthly tracking perspective, I far prefer my Fearsome Five/ex-Fearsome Five framework, because the core services ex-housing gauge, which many have been calling “supercore”, still includes components, notably hotel rates and airfares, that tend to exhibit tremendous high-frequency noise that tells us little about underlying inflation trends.

As we move forward, what Fed officials should be most concerned about with respect to underlying inflation is that price hikes in a number of broad services categories are proving stubbornly high.  Over the past 12 months, for example, recreation services prices have risen by 6.4%, education services by 3.1%, “other personal services” by 6.8%, and transportation services by 9.1% despite a 13.4% drop in airfares.  There is not much in these figures to suggest a return to 2% underlying inflation any time soon.

Other inflation gauges

There are a number of other ways to slice and dice the inflation aggregates, many of which I have highlighted in the past. The Cleveland Fed calculates a 16% trimmed-mean CPI and a median CPI, methodologies that are specifically designed to eliminate the influence of outliers.  The median CPI accelerated to 0.5% in September, the highest reading since February.  Similarly, the trimmed-mean CPI accelerated to 0.4% last month, also the largest monthly rise since February.  In other words, these gauges back up what my ex-Fearsome Five aggregate shows, and they explicitly show that the reacceleration in core inflation last month was broad rather than being driven by one or two line items.

Meanwhile, the Atlanta Fed calculates the Sticky-Price CPI.  As a reminder, economists refer to prices for certain goods and services as “sticky” when they change infrequently.  The theory behind this index is that firms that tend to raise and lower prices infrequently are likely to raise prices only when they see a sustained upward trend in prices.  Thus, looking solely at sticky prices not only filters out the volatile categories (like my ex-Fearsome Five measure does) but it also may, in theory, offer some implicit insight into businesses’ medium- and long-term inflation expectations.  In any case, the Atlanta Fed Sticky-Price CPI measure bottomed out at 2.9% annualized in June, then picked up to 3.1% in July, 4.7% in August, and 5.5% in September, yet another high going back to February; these reading are all 1-month annualized changes.

The bottom line is that no matter how you slice it, the September core CPI results were troubling, much worse than the as-expected 0.3% headline print might suggest.  It may turn out that September was simply an upside outlier.  Perhaps OER will sink back to the August pace and recreation costs will cool.  However, the latest numbers suggest that now is an odd time for policymakers to conclude that they can slack off in their efforts to return inflation to 2%.

Stephen Stanley
1 (203) 428-2556

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