Last week’s US CPI report shocked markets which were betting on US rate cuts soon. The data for March was the third consecutive monthly gain for core CPI of 0.4%. The core is up 4.5% annualised over the last 3 months, 3.9% annualised over the last 6 months and 3.8% y/y. The decline in inflation may have stalled. Larry Summers has suggested that the chance that the next rate move is up is now 15-25%. I think that is a bit low and would say 30-40%. It now seems to be a much bigger risk than recession, which most people worried about last year.
Why has inflation stalled?
The big rise we saw in 2021-22, with core CPI peaking at 6.6%, was caused largely by transitory factors as the Fed initially maintained. Shortages of durable goods, especially cars pushed up durable goods price inflation to hit 18% at the peak in February 2022. Almost every year since 1997 durable goods prices have fallen, so this was a big change. Normality has resumed with goods prices down 2% in the year to March.
But services inflation is still elevated. The problem here is two-fold. Rental inflation is still strong, at 5.7% y/y in March and other services inflation is also strong. Rental inflation is widely expected to slow, though it is taking longer than expected. We know that new rental contracts are at a slower rate of price increase – this just hasn’t fed through into the official numbers yet. But other services are linked to wage increases and these are running too high.
The Atlanta Fed wage tracker has come down to 4.7%, compared with just under 4% pre-Covid. Until this comes down all the way, service prices are likely to continue to grow too fast to be consistent with the 2% inflation target. The good news is that wage growth has already slowed quite a lot. It hit nearly 7% in 2022-23.
The labour market has normalised to a considerable extent. Job offers and the so-called quit rate are back in line with pre-Covid trends for example. But it is an open question whether this will be enough for wages and therefore inflation to be brought down ‘the last mile’. Economic growth in Q1 is estimated at 2.5%, still above the US’ long-run potential rate, after a strong 2023.
What will the Fed do?
Most likely nothing for a while. They can afford to wait as long as wage growth and inflation do not actually rise significantly from here. They may hope that the full effects of past tightening have yet to come through. A few weeks ago I would have said that was unlikely because the last rate hike was in July 2023, already 9 months ago and there was ‘only’ a 1% hike in 2023 anyway – most of the tightening came in 2022. But the rise in market rates in the last few weeks has tightened conditions again, so maybe rates will have some more impact.
The other hope is that the ‘accumulated savings’ from the Covid era will be exhausted soon so that consumer spending will fade. One way to look at this is to look at the monthly savings rate (chart below). This is simply the difference between income and spending each month and it is running at only 3.6%, well below 2019 levels of just over 7%. Perhaps it is this low because people are dipping into past accumulated savings. But when those are exhausted, savings could rise back to 2019 levels over the next year, slowing the economy. But will the savings rate rise? The rate pre-Covid may just have been a hangover from the trauma of the GFC. If we go back to pre-2008, a savings rate of 2-4% was fairly normal. And consumers today are enjoying low unemployment and high stock and house prices. Why save more?
In fact, confidence generally is picking up. The stock market is one measure but we can also see consumer confidence rising and CEO confidence up. Almost nobody expects a recession anytime soon – a big change from a year ago. Why should the economy slow?
What would make the Fed hike?
I can see two scenarios for Fed tightening – one a certain hiking case, the other a maybe. The certain case is if growth stays robust and wage growth actually accelerates. Then the Fed will have little choice though it will be very awkward if it needs to hike before the Presidential election. The other is if growth, inflation and wage growth all stay elevated but without accelerating. They probably ought to be hiking then but my guess is that they would hold out at least until December.
My central view remains that we are living through a bump in the road and that the combination of slightly slower growth and an easing labour market will in fact see wages and inflation come down by late Summer. In other words the Goldilocks world will resume. But the risk of a different outcome, with the Fed actually hiking again, is rising.
For more on all this, our latest Economics for Investment publication is out. Email info@tricio-advisors.com for a complimentary copy.