June CPI—What Happened?
The June CPI report provided no relief as both headline and core inflation rose more than expected. The financial press will report the year-over-year figures of 9% (headline) and 6% (core, ex-food and energy), but the month-over-month data is more representative of the continued price pressures since both accelerated in June vs. May (1.3% and 0.7%, respectively). Inflation continues to be broad-based and, if anything, the more persistent categories are accelerating rather than slowing down.
Digging into the Data
The data showed a continued upward trajectory that had stalled out last month. The details of the release are, if anything, more worrisome than the headlines. Goods prices have decelerated in year-over-year terms but actually rose sharply month-over-month. Services prices are the real story though—they are now up 6.2% year-over-year which is significantly driven by housing inflation—housing alone contributed 2.4 percentage points to inflation over the last 12 months. Owners’ equivalent rent is up 5.5% year-over-year, and we suspect there is more to come—the pass-through from past increases in house prices has yet to be fully felt.
While the Fed focuses on core CPI most of the time, in situations where they are worried about inflation expectations becoming unmoored, headline CPI becomes important since that’s the basket that consumers actually consume. In that sense, the Fed may take some comfort from the recent decline in gasoline prices, which tend to drive inflation expectations. We will likely see some relief in headline CPI next month, assuming that gas prices don’t move higher in the second half of this month.
The only category that fell in June was airfares, and that was a simple correction of 1.8% after three consecutive months of gains between 10% and 20%. That’s hardly relief and given the visible pressure on the airline industry to stay staffed up, it’s unlikely to persist. Indeed, the relationship between labor market tightness and services inflation has held remarkably well. That illustrates exactly what is going to be necessary to slow prices—the labor market will have to weaken.
We Don’t Envy Jay Powell
This data continues the recent pattern and illustrates the challenge for the Fed. When we look at the economic growth data, it is obvious that there is a significant deceleration underway. But when we look at the inflation data, it is the polar opposite—price pressures aren’t abating and warrant significant policy tightening in the next few months. Chair Powell has been very clear that fighting inflation is job one, even if that causes a recession, and unless the Fed changes its tune very quickly, a severe slowdown, possibly recession will indeed ensue.
We expect that the Fed will raise the Fed funds rate by another 0.75% at the end of this month … and perhaps go a full 1%. Front-loading policy tightening gives the Fed a fighting chance to bring down inflation in a reasonable time frame. The less aggressive they are, the less likely their success. The cost of that tightening is severely slower growth.
Our Outlook from Here
Our economic expectations are for the slowdown to continue into 2023—US GDP growth next year should be close to 1%. At this pace, the distinction between “recession” and “near miss” is irrelevant. Growth will have slowed enough, and unemployment increased enough, that it will feel like a recession even if the National Bureau of Economic Research doesn’t categorize it as such. For investors, the question, though, remains whether this likely slowdown is already priced in. We think there’s a credible argument that it is. Assuming a contraction in PE ratios given the higher interest rates and slower growth as well as flat earnings growth in 2023 (consistent with flat economic growth), the equity bear market (down ~20%) may have already priced in the coming slowdown.
A well-diversified allocation that can withstand inevitable volatility is worth considering, particularly at times like these.
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