The week’s headlines centered on inflation. First, the CPI (Consumer Price Index) will be released on July 12th. As previously predicted, the rate of inflation has begun to decline. The +0.2% increase in headline (0.180% to the third decimal place) and core inflation (+0.158%) was lower than the +0.3% increase anticipated (for both). This brought the mysterious annual inflation rate to 3.09%.
The year-over-year comparison provides little insight into the current trend. Three- and six-month calculations provide more accurate trend information.
The most recent three-month annualized rate of change is 2.7%, while the six-month annualized rate of change is 3.3%, obviously trending upwards. Services excluding rent and energy, the main sub-index cited by Fed Chair Powell, deflated in June (-0.005%). How likely is it that Powell will discuss this index during the July press briefing? (Answer: Nil)
Then, on Thursday (July 13), the headline PPI (Producer Price Index) figure for the month of June, at +0.1%, came in below the consensus estimate (+0.2%). The annual rate of change in headline PPI is only +0.1% year over year.
This compares to +6.4% in December and +11.2% in June of last year. Over the past six months, the annualized rate of change in the PPI was -0.3%, and over the past three months, it was -0.7%! Again, the trend is toward price reductions! Examining “Core Crude PPI,” which measures prices at early phases of production and is a very reliable leading indicator for the more popular CPI, we observe that June’s month-over-month result was -2.4%, and this measure is -13.6% lower than in June ’22.
Observe the sharp downward trends in both the CPI and PPI in the chart located at the top of this blog.
Despite these extremely positive trends, Fed governors continue to assert that interest rates will remain “higher for longer.” Consequently, the markets presently assign odds of 90% or higher that the Federal Funds rate will increase by 0.25 percentage points (25 basis points) at the upcoming July 26–27 Fed meeting.
Given the above inflation trends and the fact that monetary policy has lengthy lags, it does not appear that another rate hike is necessary. (And some commentators now argue that the current rates are excessive; we agree.) Nonetheless, such an increase appears inevitable, lest the Fed lose credibility and allow its influence on the yield curve of the free market to diminish.
The Fed did announce this week that James Bullard, president of the Federal Reserve Bank of St. Louis, will leave his Fed position in mid-August to join the Purdue faculty. Bullard, the Fed governor who has been the most vocal advocate of rate hikes, indicated that he would not participate in any rate-setting discussions or conclusions during the Fed’s July meetings.
As the preceding discussion indicates, we hope that this event signals the beginning of a more dovish Federal Reserve, but we are not holding our breath.
The final column on the right indicates what the headline CPI would be if the monthly inflation rate remained at 0.2% as it did in June. Because we anticipate a recession, we also included columns for +0.1% and +0.15% growth. At the current monthly rate of +0.2%, the headline CPI for December ’23 would be 2.85%, and it would decline to 2.43% a year later (right-hand column). As shown in the data, at +0.1% or +0.15%, the CPI headline would be 1.21% or 1.81% by this time next year, well below the Fed’s 2% target.
Prior to the end of the year, it is highly probable that the monthly CPI readings will be negative. So, we continue to ponder (with credibility!) why the Fed is increasing interest rates. Perhaps Bullard’s retirement indicates a more lenient Federal Reserve in the future.
Projected Monthly Rates of Change for Monthly Inflation Rates
Caution is warranted here. In the table’s CPI column, record the CPI index for May, June, and July 2022. The headline inflation rate is the percentage change in the index over the previous year. Therefore, 3.09% represents the percentage change from June ’22 to June ’23 (i.e., 303.841 versus 294.728). Between May ’22 and June ’22, the index experienced a significant increase (from 291.268 to 294.728). This phenomenon is known as the “base effect.”
The annual percentage change calculation was affected by the much larger denominator in the June ’23 calculation. This is one reason why the headline rate of inflation dropped one full percentage point (from 4.13 percent to 3.09 percent). Observe that the CPI index decreased marginally in July (from 294.728 to 294.628). When July’s CPI data is released in mid-August, this will have a negative impact on the headline CPI.
If month-over-month inflation is between +0.1% and +0.2%, which would be very encouraging, the headline year-over-year rate will rise to the range of 3.2% to 3.3% under almost any plausible scenario, as shown in the table.
Again, this would be due to the “base effect” of the July ’22 drop in the index. This may cause a disturbance in the markets, but there is no cause for concern as long as the monthly change remains moderate.
There is a substantial correlation between the Institute for Supply Management’s (ISM) Manufacturing Prices Paid Index and the Consumer Price Index (see chart). If the past is any indication, as is evident from the graph, inflation will continue to decline.
Employment – Less Than Apparent
Earlier in the month, employment reports indicated that the headline Payroll Report number was +209K. This was the lowest reading in the past two and a half years (since December 2020). This was the first occasion in 15 months that the consensus forecast exceeded the actual result.
Starting with the headline total of +209K:
The Birth/Death add-on for small enterprises (which were not surveyed) was +60,000. This is a trend line number that is merely added by the BLS; it disregards the business cycle. According to The Challenger Gray and Christmas Company, layoffs in June were +25% higher and hiring announcements were -87% lower compared to June ’22. This was driven by declines in the leisure/hospitality, finance, and retail sectors; initial claims for unemployment have increased.
The four-week moving average is now +45K higher than it was in February; deducting the monthly revisions (-110K) and the Birth/Death add-on (-60K) yields a net increase of only +39K, which is nowhere near the +209K headline. And since the government added 60K jobs, the private sector lost over 21K positions.
But hold! There is even more. The growth in second jobs (multiple job holders) was +233K, and these individuals now account for 5% of the labor force. This is in the upper range of the last decade and is a reliable indicator of economic strain. “Part-Time for Economic Reasons” (those with a part-time job who want a full-time job but cannot obtain one) is another such indicator.
These increased by +452K in June, the largest increase since the pandemic lockdowns in April 2020! In addition, employment in the “Temporary Help” sector decreased by 13,000 in June and has declined in five of the previous seven months.
When headhunters are cutting off their own heads, it is intuitively apparent that employment must be poor. Observe the downward trend in nonfarm payrolls beginning early in 2022, particularly in the private sector.
The employment report was quite lackluster, and we believe it is a portent of things to come. (We observe that Microsoft MSFT announced additional layoffs in the week ending July 14 in addition to the 10,000 announced in January.)
According to the incoming data, it appears that the Fed is as incorrect about “elevated” inflation as it was about “transitory” inflation two years ago. Unfortunately, it appears that this Fed pays little heed to detailed analysis. It appears that they embrace the headline numbers without further investigation.
Consequently, we believe that, for the sake of credibility, a +25 basis point hike in rates on July 27th is a foregone conclusion, as the Fed has been telling markets for over a month (since its June meeting) that rates will be “higher for longer,” and their June dot-plot actually indicates two more rate hikes before the end of the year.
The most recent CPI and PPI numbers are quite recent, and their lack of credibility is unlikely to deter the Fed from implementing another rate increase. We would not be astonished, however, if the decision to hike was not “unanimous.” And the retirement of Bullard, the Fed’s most hawkish member, is an encouraging sign that the eventual shift toward “ease” will not be as difficult to achieve as we previously believed.
Recent inflation data, as discussed previously, has persuaded markets that this will be the final rate increase of the cycle. This is reflected in the low September hike probabilities on the market. We concur with this assessment, as we anticipate that the inflation rate will continue to decline and may even turn negative by the end of the year.
The Fed’s economic staff expects a mild recession to commence in this quarter (Q3) or the following quarter (Q4). When the recession becomes widely recognized in the future, the Fed will likely lower interest rates when the U3 unemployment rate (currently 3.6%) exceeds 4%. Since the Fed views the neutral rate (one that is neither “tight” nor “loose”) as being in the vicinity of 2.5%, we do not anticipate them lowering rates below 2% unless the Recession is particularly severe.
When the recession becomes widely recognized and the baseline scenario is established, equity markets are unlikely to perform well, whereas fixed-income investments will thrive.