“We’re seeing deflation. So I’m feeling much better about inflation in terms of pricing versus a year ago. But we’re not finished…At Walmart, we are now seeing prices that are in line with where they were 12 months ago.”
— Walmart U.S. CEO John Furner on their Q1 2024 conference call
Have Inflation concerns returned? We’ve long been prepared to move on from the over analysis of monthly inflation data, confident the majority of inflation would prove transitory, leaving investors to focus on economic growth and the uneven recovery across different industries post-pandemic. However, recent stubbornly high inflation readings warrant some further investigation.
While the Consumer Price Index (CPI) is an undeniably important inflation measure, it isn’t necessarily the timeliest measure for market pricing. Infrequently purchased items like cars and homes are not immediately incorporated into the index at their current market rates. This causes the index (which measures prices paid) to lag changes in market rates for these types of purchases.
The areas currently driving higher core inflation, reflected in the chart below, are precisely those forms of goods and services.
Auto insurance, typically re-set annually, was underpriced in the post-covid recovery as auto recovery and repair values increased extremely quickly, forcing policy makers to raise premiums suddenly in response. Those large price increases have already been put in place, but they continue to contribute to ongoing inflation as more consumers are forced to re-subscribe at the new rates. Similarly, the far and away largest contributor to on-going inflation, housing, continues to reflect price increases that have generally already occurred, but are simply flowing through to CPI as individuals change their housing circumstances.
Market rents are exhibiting relatively normal increases and housing, as measured by the CPI, should eventually follow suit. These effects had given us confidence that in the near-term inflation would head lower, and we see little evidence of a change in trend here. None of this is to say inflation can’t re-emerge given continued strong wages which propel marginal consumption, but that isn’t what’s driving the headline inflation we are dealing with currently.
The Importance of Expectations:
While the CPI doesn’t perfectly capture market prices, it does reflect the budget of aggregate consumers—how much they are spending at the moment. As consumers’ ongoing expenses change so too may their spending habits and their expectations for future price increases.
These expectations are crucial to the economy. High inflation is bad because it erodes purchasing power more quickly which people don’t like (obviously), but it also begins to influence their behavior in perverse ways. In a world with sky-high inflation a Jetski is the ultimate investment (fun today and the money’s worthless tomorrow). Conversely expectations of deflation are even more economically dangerous because individuals are likely to horde cash (keeping it out of the economy) as its value increases over time.
While market-pricing implies continued inflation above 2% for just a couple years, longer-term expectations have been remarkably stable throughout the entire post-covid recovery.
Interest Rates and the Neutral Zone:
If the market has had relatively subdued inflation expectations, then the ongoing obsession with inflation is more a reflection of the Federal Reserve’s own obsession with inflation. Thus far there is little evidence that higher rates on their own have been responsible for curtailing much of the inflationary spike we saw in the post-covid recovery.1 The Federal Reserve’s own estimates would have included substantially more “pain” than markets have endured, lower growth and high unemployment. However, restrictive interest rates are not without risk and the longer they persist the longer the economy risks incurring a more painful outcome.
Some might argue rates aren’t actually restrictive because there hasn’t been any “pain” yet (some economists even seem to yearn for it!). A simple examination of the market for funds (the one governed by interest rates) shows a sizeable impact. Mortgage originations are at post 2008 lows and banks are holding nearly the same amount of loans as they were two years ago despite substantial economic growth.
If we can agree interest rates sit at a restrictive level, then lowering them shouldn’t be perceived as “stimulating” but simply a nudge closer to the elusive “neutral” level. Some recent Fed commentary leads us to believe they are well aware of this dynamic which is why they seem prepared to lower rates (sometime soon) without watching economic data substantially deteriorate. A scenario everyone should welcome.
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The Standard & Poor’s (S&P) 500® Index is an unmanaged index that tracks the performance of 500 widely held, large-capitalization U.S. stocks. The MSCI Emerging Markets Index captures large and mid cap representation across 27 Emerging Markets (EM) countries. With 1,392 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. The MSCI EAFE Index is an equity index which captures large and mid cap representation across 21 Developed Markets countries around the world, excluding the US and Canada. With 876 constituents, the index covers approximately 85% of the free float adjusted market capitalization in each country. The Bloomberg Aggregate Bond index is designed to represent the full range of investment-grade bonds traded in the U.S. It is composed of more than 10,000 issues. U.S. Treasuries represent nearly 40% of the index. The remaining components represent the debt of major industries including real estate, industrial companies, financial institutions, and utilities.
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Consumer prices (CPI) are a measure of prices paid by consumers for a market basket of consumer goods and services. The yearly (or monthly) growth rates represent the inflation rate.
The Zillow Observed Rent Index (ZORI) measures changes in asking rents over time, controlling for changes in the quality of the available rental stock. The PCE price index reflects changes in the prices of goods and services purchased by consumers in the United States. The New Tenant Rent Index (R-CPI-NTR) measures prices renters would face if they changed housing units every period.
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1 See our link to quarterly letters and paper discussing “mortgage rate lock-in” and “corporate lock-in”
