The Ongoing Battle for Control over Inflation

September 2023



We thought this month might be a good time to talk about inflation, mainly because the market is pretty excited about how much inflation has dropped in the past year, and there's the belief by some that maybe inflation won't be a problem in the very near term. Our view is a little bit different – we think the Fed still has an awful lot of work to do to bring inflation back under control, so let’s start by taking a look at a couple of charts.

Chart 1: 0:39 – In this first chart, we're taking a look at the Consumer Price Index (CPI). This seems to be the most popular of all the measurements of inflation. It's been around for more than 100 years, and it's often used for cost-of-living adjustments, like with contracts for labor or Social Security.

In the chart, “Inflation: CPI”, you can see how inflation has changed so much in the last year or so. It moved up very quickly from the recessionary period, hitting a peak of 9.1% last summer, and has since come down significantly.

Right now it is standing at 3.2%, so it dropped off about six percentage points, and that's really what has people excited about the declines – it's very close to the Fed's target rate of about 2%. But our view is a little bit more bear. We think getting inflation back to 2% will be difficult for the Fed. It's going to take some time, and it's going to be a bumpy ride.

Chart 2: 1:37 – To look at inflation in a little bit more detail, the next chart, “CPI: Components”, does a nice job comparing what inflation has been like for the last year to what it was before the pandemic.

If you focus over on the left-hand side (the overall inflation in the dark blue column), for the last year, it's been at 3.2%. The light blue is what it was in 2019 – again, before the pandemic. It has moved up almost a full percentage point. Looking at the eight major categories within inflation, you can see that housing has had the biggest change, up 6.2% in the last year, which is a much bigger increase in what we've seen in the past. As for Transportation, that's heavily influenced by the price of gasoline and motor oil, and, in the last year, those prices have come down, so that's why it's in the negative territory.

Food and Beverage are much higher than what we had before the pandemic. Not so much in terms of the food that you eat at home, but because of going out to dinner, the labor costs have gotten much higher. Then, Medical costs have been in a negative territory in the past year or so. That's driven by the way that CPI calculates medical costs, which has to do with profitability of insurance companies. The others are much smaller in terms of their size, so their impact isn't nearly as bright on the overall number for the headline, CPI inflation.

Chart 3: 3:02 – To take a look and put it in some sort of context, the next chart (CPI: Components, % change y-o-y and sector weighting, seasonally adjusted) does a nice job of doing so. It's the same eight categories that we have – the vertical (line) that you see is the percent change year over year, the horizontal is the weighting, and as you can see on the left-hand side, this sort of “Dodger blue” color, Housing makes up the biggest component of CPI. So for the Fed to get this inflation number under control, they really need to get housing costs under control. That's followed by Transportation and Food & Beverage, and, of course, Medical care.

Chart 4: 3:37 – To take a look at the major components in more detail, we have some new charts here. This first one “CPI: Energy” focuses on energy prices because that's, again, the driving force of transportation. The columns represent the three-month change in energy prices. The line is representing the year-over-year change. The reason we look at the three-month change is it gives us more of a contemporary view of what's in current news and how it's driving current prices. But you can see energy prices have been in negative territory for the past year or so, and again, that's helped bring down inflationary pressures.

Chart 5: 4:12 – In this next chart “CPI: Medical Services”, the same thing is going on with medical costs. As you can see, since last October, those have been moving down pretty significantly. Again, due to how CPI calculates medical costs for inflation, that will change in the new fiscal year for the government, and we'll see those prices start to move back up again.

Chart 6: 4:32 – And then, finally, Food & Beverage costs: Again, that's been moving down significantly. It went up quite a bit, due to supply chain problems, and, of course, the war in Ukraine, but has since started to come down quite a bit, and that's very important.

Now for inflation, and especially in terms of what the Fed is focusing on, they tend to look at Core Inflation. Core Inflation takes away food and energy prices, the reason being is that the Fed has very little control of food or energy prices. Food prices tend to be dominated by weather, and energy prices more by geopolitical issues that are going on. Also, they tend to be very volatile, so it makes it very difficult to forecast future inflation with volatile components like that, so they look at what they call Core Inflation.

Chart 7: 5:21 – And in this next chart “Inflation: CPI & Core-CPI”, you can see how Core Inflation has been performing. Again, this is CPI, but just taking out the components of food and energy. Core Inflation, the light blue line (shown), has not come down as much in the last year. Again, a lot of that is because food and energy prices came down, forcing the headline number down quite a bit.

Chart 8: 5:42 – The following chart “Core CPI: Goods and Services” is another way to take a look at CPI in greater detail. Here, we're taking a look at the difference between service costs and goods cost. The dark blue is the cost of goods, and this represents about one-third of CPI. Following the recession and the early stages of the pandemic, goods prices moved up significantly because of the supply chain problems and the overwhelming demand for an awful lot of goods as homeowners wanted to keep their families amused. So they pushed up prices, but as the pandemic moved into the rearview mirror, those prices have come down significantly.

The lighter blue line is service cost. That continues to be quite high, and this is a concern for the Fed because service prices are far more sticky than goods prices.

If a dealer has too many TVs, they put them on sale, and that clears the excess inventory, and the sale price is registered, and that's what brings down the inflation. But service prices work a little differently.

Chart 9: 6:44 – So within services, that's made up of two major components: One is Housing and the other part is Non-Housing services, which are things like going to the dry cleaner or getting your car fixed – areas of the economy where labor is a very important part of the cost.

Looking within the Housing component, you can see in this chart that both the annual change and the three-month change is moving down – that's exactly what the Fed wants to see. But within Housing, which is a large component, the biggest aspect is basically the cost of owning a home. The Fed doesn’t look at the price of homes because there's an investment component there.

Chart 10: 7:24 – Instead, they create something else that's called Owner Equivalent Rent, and that is coming down, but not nearly as fast as the overall index. This is the part that's moving inflation down very, very slowly.

Chart 11: 7:38 – Then the other part of service inflation is called “Super Core” – at least, that's what a few economists like to call it. This is service costs without the Housing component. Again, it's related heavily to the cost of labor. It, too, is moving down, which is in the right direction, but it's doing so very, very slowly. And as you can see, the rate is still well above what the Fed wants, closer to 2%.

Chart 12: 8:06 – But CPI is not the only measurement of inflation. There's another measurement that's quite popular and one that the Fed actually looks at most. It comes from the personal spending report that comes out at the end of the month, and it's called Core PCE: Personal Consumption Expenditures. Again, Core takes out the food and energy prices.

Here on the chart “Inflation: CPI & Core –PCE”, it's the light blue (line), and, as you can see, the decline in Core PCE has not been as significant as what we had seen in CPI.

Fact is, it's only come down about 1.2%. It's much stickier than what the CPI price is, but what makes this report attractive to the Fed is far more details that you can take a look at in terms of what's causing inflation. Is it a supply problem? Or is it a demand problem?

Chart 13: 8:53 – This chart “Core PCE: Supply & Demand Drivers”, really breaks that down. This is from the San Francisco Fed with research that they do. It breaks down in terms of what's causing inflation: Is it supply issues, which you can see at the bottom, the very dark blue, moved up following the pandemic period because of the supply problems that we had. It's now come down mostly back to the level that we had beforehand.

The way they're able to calculate this is that prices are moving up, but the amount of goods being sold is declining, which means it's a supply problem.

The middle blue that you see there, that sort of darker blue in color, that's demand driven. That's where both supply and demand are moving up, and that's causing those prices to move.

That's what the Fed wants to correct: They want to continue to reduce the demand for these goods and services. And then the gray at the top is the part that they can't quite figure out whether it is supply or demand. But it's the light blue in the middle that's the focus for the Fed. They need to keep interest rates higher for longer to help reduce that demand.

Summary: 10:01 – So, with the Fed's target of 2% inflation, the goal of the Fed is not to get inflation to 2%, but rather have it on the way to 2% and be sustainable at 2%, and that, we think, is going to take some time.

Jerome Powell recently said that he does not expect it to get there until 2025, and to us, that means that the Fed will have to keep interest rates higher for longer, because what they're looking to do is reduce that demand for a lot of goods and services, and that will drive down the inflation to what they want.

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