The Big Idea
The Fed’s very optimistic view on inflation
Stephen Stanley | October 4, 2024
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.
The substantial moderation in the labor market captured the attention of policymakers over the summer and ultimately drove the FOMC in September to cut rates by 50 bp. Nonetheless, Fed officials acknowledged that they were afforded the luxury of moving aggressively by a relatively benign near-term inflation outlook. It appears that Chair Powell and some other committee members have an awfully optimistic take on the inflation data, perhaps looking at prices through rose-colored glasses.
Shifting data, shifting rhetoric
The core inflation numbers over the past few years have exhibited a number of dramatic and unexpected turns. In 2023, core inflation remained stubbornly high in the first half of the year. The core PCE deflator rose by 0.3% or more in each of the first six months of the year, advancing at a 4.1% annualized pace. Then, suddenly, core inflation softened, increasing by only 0.1% in four of the next five months. In the final six months of 2023, the core PCE deflator increased at a 1.9% annualized clip.
On the back of that performance, Fed officials and financial market participants entered 2024 hoping that inflation had been mostly brought under control. In fact, for a time in early 2024, financial markets were pricing in over 150 basis points of rate cuts for this year, beginning as early as March.
Unfortunately, core inflation reaccelerated sharply in early 2024. For the first four months of the year, the core PCE deflator rose at a 4.1% annualized pace. The faster inflation numbers dashed hopes of early rate cuts and kept the FOMC on the sidelines through the summer.
However, once again, core inflation swung dramatically. Over the past four months, May through August, the core PCE deflator advanced by only 0.1%. and the annualized clip over the past four months works out to 1.8%. The last two four month periods are remarkably similar to the corresponding first half and second half of 2023. Indeed, the year-to-date annualized core PCE inflation rate through August of 2.93% is not markedly different from 2023’s 3.04% December-to-December advance.
As was the case late last year, Fed officials have been quick to embrace the lower readings. Here is a sampling of recent Fed comments since the September FOMC meeting:
- Kashkari (September 23): “It now appears that while it remains too soon to declare victory in our inflation fight, we have made substantial progress, and the disinflationary process appears to be on track.”
- Bostic (September 23): “Inflation has fallen faster than I had expected, and the most recent data solidify my conviction that the US economy is indeed sustainably on the path back to price stability.”
- Goolsbee (September 23): “Inflation is way down from its peak. Indeed, for multiple months, it has actually been coming in at the 2% target – and expectations data suggest the market doesn’t think it’s going back.”
Other policymakers are not quite as relaxed, but they appear to be in the minority.
- Bowman (September 24): “The progress in lowering inflation since April is a welcome development, but core inflation is still uncomfortably above the Committee’s 2 percent goal.”
- Barkin (October 2): “There is still work to do on inflation. While down from its high, inflation remains above our 2 percent target. I don’t expect 12-month core inflation to drop much further until 2025.”
Breaking down core inflation
Since late 2022, Chair Powell has discussed core inflation by dividing the aggregate into three buckets: core goods, housing services, and core services excluding housing. Most recently, he used this construction in his September 30 speech to the NABE. We can assess the underlying inflation picture by examining each of these components relative to pre-pandemic trends as well as Powell’s description of each.
Core goods. This one is relatively noncontroversial. Core goods prices spiked during the supply chain difficulties caused by the pandemic and have since returned to roughly pre-pandemic trends (Exhibit 1). In 2018 and 2019, the goods component of the core PCE deflator declined by 0.3% and 0.5%, respectively on a December-to-December basis. After spiking to a high of 7½% in early 2022, core goods inflation quickly receded. The December-to-December 2023 reading was flat, and the current (August) year-over-year decline is 0.5%.
Exhibit 1: Core PCE deflator goods inflation
Chair Powell’s assessment: “Core goods prices have fallen 0.5 percent over the past year, close to their pre-pandemic pace, as supply bottlenecks have eased.”
Housing Services. Shelter cost inflation has been an ongoing source of frustration for Fed officials. For two years, policymakers have been arguing that while shelter costs were high now, they would be coming down soon because real-time measures of home prices and rents have fallen dramatically. A few years ago, the data suggested that the shelter cost measures (owners’ equivalent rent and rent) in the CPI and PCE deflator lagged real-time industry price data by about a year. Now, the thought is that the lag is closer to two years.
Chair Powell’s assessment: “Housing services inflation continues to decline, but sluggishly. The growth rate in rents charged to new tenants remains low. As long as that remains the case, housing services inflation will continue to decline.”
Powell’s take, which has not changed much for the better part of two years, is starting to look questionable. The year-over-year change in the Zillow rent index has been relatively steady since around mid-2023, which is to say that the underlying trend in rents has barely budged for two years (Exhibit 2). Even with the longer lags that Fed officials are suggesting, it is unclear that there is much lagged disinflation yet to be seen in the shelter costs measures.
Exhibit 2: Zillow rent index year-over-year change
Note that the year-over-year change in this index has been relatively steady since around mid-2023, which is to say that the underlying trend in rents has barely budged for two years. Thus, even with the longer lags that Fed officials are suggesting, it is unclear that there is much lagged disinflation yet to be seen in the shelter costs measures.
Having said that, I would agree with Chair Powell that some further disinflation is likely. The Zillow index (other rent measures show similar results) has more or less returned to pre-pandemic levels. In 2018 and 2019, shelter costs rose by around 3.5%, so that is in my view our ultimate destination in the best case scenario. The current year-over-year advances are 5.4% for OER and 5.0% for rent, so there is some room for additional cooling.
Nonetheless, it is worth noting that there is not much downward momentum in the numbers. The latest six-month annualized figures are 4.9% for OER and 4.5% for rent, only about a half a percentage point lower than the year-over-year advances. The three-month annualized gains are about 4.5% for both. The gap between 4.5% (current pace) and 3.5% (the pre-pandemic rate and where we may ultimately settle) is noticeable, but with shelter costs accounting for less than 20% of the core, a one percentage point deceleration in the component would pull core PCE inflation down by less than two tenths of a percentage point. And the longer shelter costs remain stubbornly high, the more likely it becomes that this component will remain stuck above 4%.
Core Services ex-Housing. This third bucket accounts for the bulk of the index and has been identified by Powell and Fed officials as the key swing factor in bringing inflation back down to 2%.
Chair Powell’s assessment: “Outside of housing, core services inflation is also close to its pre-pandemic pace.”
This one is a bit of a puzzle. I am not sure how Chair Powell is parsing the data to reach that conclusion. In the years prior to the pandemic, when core inflation ran just below 2%, the year-over-year change in the PCE core services ex housing aggregate was always near 2%, ranging between 1.5% and 2.5% (Exhibit 3). It has certainly come down from its 2022 peak, but the measure in recent months remains noticeably above 3%.
Exhibit 3: Core PCE deflator services ex-housing
The latest year-over-year reading is 3.3%, while the year-to-date annualized gain through August is 3.4%. It is true that the readings over the past four months have been more benign, summing to an annualized pace of just over 2%. Perhaps this is what Chair Powell is referencing. However, that seems like cherry-picking, to focus only on the most recent benign readings and ignoring the surge in prices that occurred early in the year.
This is especially the case when considering that Powell and others at the Fed have downplayed the high readings early in the year as at least partially due to residual seasonality in the data. I agree that residual seasonality accounts for the recurring pattern of high inflation readings to start the year and lower readings later in the year. But if we stipulate that to be the case, then it is unfair to then represent the lower inflation readings as indicative of the underlying trend. By definition, seasonality in the data has to cancel out over the course of the year. So, if the early-year readings are distorted (upward), then the other months of the year have to also be distorted (downward).
But wait, there’s more
The data for the three major buckets of the core inflation aggregate, as defined by Chair Powell and other Fed officials, already seem less comforting than Powell and others are suggesting. But the story gets worse if we further deconstruct the numbers.
For those who follow my monthly CPI preview and recap pieces, the Fearsome Five grouping should be familiar. These are the five components of the core CPI (new vehicles, used vehicles, apparel, airfares, and hotel rates) that show the most high-frequency volatility. Stripping them out, in my view, offers a much more reliable read on underlying core inflation in any given month than the core measure itself.
To set the baseline, in 2018 and 2019, the Fearsome Five were essentially neutral, adding a mere 4 basis points to the core CPI in 2018 and subtracting 2 basis points in 2019. The rest of the core CPI contributed 2.2% in 2018 and 2.3% in 2019. Presumably, that is more or less what we should aspire to, though we could likely afford modest higher readings since the core PCE deflator averaging a bit less than 2% during that period.
Last year, the Fearsome Five contributed a net -2 bp to core CPI inflation, while the rest of the core contributed 3.86 percentage points. The results so far this year, incorporating four “bad” months and four “good” months are that the Fearsome Five have contributed -25 basis points total, or -3 basis points per month, while the rest of the core has contributed 29 basis points per month. As a result, while the core CPI has risen so far this year at a 3.16% annualized rate, the corresponding non-Fearsome Five core inflation rate is 3.51%, more than a third of a percentage point higher. The gap in the core PCE deflator would be a bit less because used vehicles (one of the two main downward influences in the Fearsome Five, along with airfares) has a lower weight in the PCE deflator than in the CPI, but the point still holds. The core numbers are being flattered, especially over the past several months, by sharp declines in used vehicle prices and airfares that cannot be expected to continue indefinitely. In fact, a rebound in those two categories later this year seems plausible, which would at the margin nudge the core inflation readings higher.
Conclusion
While I would agree with Chair Powell and others at the Fed that core inflation is heading in the right direction, I view Powell’s latest assessment of trends in core PCE inflation as unrealistically positive. I see Fed Governor Bowman’s (or Richmond Fed President Barkin’s) description as more accurate. As long as the monthly headline and core inflation figures remain benign, the FOMC has a free hand to continue cutting rates as rapidly as the labor market data dictate. However, I suspect that the inflation dragon may not be dead just yet and that we may see it rear its head again before the Fed eventually slays it and returns inflation back to 2% on a sustained basis.