Inflation downturn | Financial Times

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Five questions on the inflation report

Yesterday’s April CPI data was indeed quite confusing. Below, five clarifying questions and our best stab at the answers.

Why was the reaction from experts and the market so mixed? Probably the noisy data. Andrew Hunter, Capital Economics, found it uncomfortably hot:

The 0.4 per cent m/m rises in headline and core consumer prices in April leave core inflation at 5.5 per cent, broadly unchanged from its level earlier this year, further showing that the previous downward trend has stopped. We don’t think this by itself will be enough to convince the Fed to hike again at the June FOMC meeting, but it does suggest the risk that rates may need to stay high for a bit longer than we assumed.

Ian Shepherdson of Pantheon Macroeconomics, on the other hand, thinks the temperature is dropping well:

The increase in core-core CPI [core inflation excluding the noisiest components] it was the lowest since July last year and marked the second consecutive improvement after dismal numbers in January and February. . . The reason to expect future data to look more like April than previous highs is quite strong and centers around the labor market. . . The outlook for core inflation, in short, is improving.

The market was equally equivocal. The yield on the rate-sensitive 2-year Treasury fell 11 basis points, suggesting a dovish ratio; the expectation implied by futures for the year-end fed funds rate also declined. But stocks missed the message and just moved.

The reason for the confusion, as far as we know, is that the report was full of strange outliers. But the totality of the data looked encouraging.

All In April, basic goods inflation was driven by a whopping 4.4% monthly jump in used car prices (more on that later). Reception services, the beating heart of inflation, looked calm for the second month running (more on that later). Core non-residential services, the Fed’s main target, fell to 0.1 percent (less than 2 percent annualized). This is incredibly low and reflects the volatility of hotel prices and airfares. But it suggests, at the very least, that prices for services aren’t spiraling out of control.

Why isn’t core inflation falling faster? Shelter, above all. THE Labor Statistics Office’ Its own graph, it must be said, does not paint an encouraging picture of core inflation:

Year-over-year core inflation has remained stagnant at 5.5% since January. What does it give? The answer is familiar, but it bears repeating and updating: The problem is that CPI haven inflation is a lagging indicator. Because it covers both existing and new leases, its constituent prices only update annually or even less often. However, there are several more timely measures by the private sector, which include only new leases. THE Zillow’s Observed Rent IndexFor example, look at list prices for vacant rental units. This makes it much more volatile, as well as more timely. Below is CPI shelter inflation lagged 12 months, relative to the Zillow measure.

The twist we saw in new rental listings about a year ago appears to finally be taking hold in the CPI haven, suggesting that the measure will steadily decline in the months ahead. The pig is making its way through the python. The welcome change in the trajectory of the CPI haven is even more visible when looking at it on a month-to-month basis. We have now had two months of solid progress:

The housing inflation sub-component increased on a monthly basis, from 0.5% to 0.6%. But this likely obscures the underlying trend. The rent component is split into small and large cities, and the small city series is very volatile. The more stable series of major cities has been on a steady downward trend, especially over the past two months:

Aichi Amemiya, Nomura’s inflation specialist, offered us this reading: “The long-awaited trend of rent moderation began in March. We saw some month-over-month inflation reversal in April [but] the partial reversal came from small towns. Rental inflation in major cities has remained fairly low, after easing in March. I mainly monitor rent inflation in major cities, because they are less volatile and represent the underlying trend in rental inflation.”

In short, a stable trend in underlying inflation now plus the lagged safe-haven effect that is sure to kick in later equals good news. But there was one other thing that contributed to the flat trend in core inflation in April: used cars.

What the heck, used cars? Don’t take them too seriously. IPC’s idiosyncrasies often come as surprises, but not this one. Many Wall Street economists had predicted higher used-car prices, for the simple reason that the wholesale used-car indices, which drive the CPI, saw prices rise in January and February. Manheim’s used car index jumped 9% between December and March, but that didn’t last. Chart from Pantheon Macroeconomics:

Omair Sharif of Inflation Insights adds: “We will see more increases in used car prices in next month’s report. But after that, I think we’ll most likely see it come out of boiling point [by June and July’s CPI]. Mainly, what we’ve seen has been a rapid increase in demand, especially in January, which is starting to fade. [It was so fast that] we went from oversupply in December to undersupply in January. It was a very quick turnaround in the market, kicking off a frenzy of putting things up for auction.

With wholesale prices already starting to fall and the post-Silicon Valley Bank credit crunch further limiting auto loan financing, used-car inflation doesn’t sound too scary.

How does this fit into the bigger macro picture? Neatly. Most of the data tells the same believable story: An overheated economy is cooling down from a high. The still tense labor market is gradually slowing down; growth is driven by consumers; and the industrial economy is in something like a recession. In that context, it makes sense for inflation to come down a little, and it does. If housing and goods inflation trends continue, core inflation is expected to decline.

How will the Fed take it? With cautious optimism. April data helps the Fed triple goal: goods inflation subdued, shelter inflation declining and non-housing basic services inflation significantly lower. A recent mystery has been why asset inflation has not always come down in sync with flat spending on goods and shrinking manufacturing. April’s CPI eased the tension: inflation of basic goods other than used cars was close to zero. The shelter is also coming down. Non-residential basic services have shown attractive progress, although it is too early to tell whether they will last.

All in all, we think a Fed pause in June is more likely now than it was yesterday morning. But rate cuts later this year don’t look any closer, no matter what the futures market tells you. (Wu & Armstrong)

A good read

The return of the monkey throwing darts (and by monkey we mean our former colleague Spencer Jakab).