Inflation Is Much Tamer Than Headline Data

I posit that the recent speculation of a more hawkish Fed is based on headline data and that the deeper data still suggests a cut in June.

The headline CPI data

On March 12^th, the Bureau of Labor Statistics released the

Consumer Price Index (CPI) report.

Inflation came in a bit hotter than the market was expecting and above the Fed’s 2% target.

“The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.4 percent in February on a seasonally adjusted basis, after rising 0.3 percent in January, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all items index increased 3.2 percent before seasonal adjustment.”

This number spooked the market into thinking the Fed will cut later than expected and perhaps fewer times than expected. In market forecasts, it nearly eliminated the chances of a March cut and reduced the chances of a June cut to just over 50%. As a result, the 10 year Treasury yield (US10Y) spiked back up to over 4.3% from just 4.08% prior to the news release.

Quite a reaction, and from a headline standpoint, I get it. Inflation had been trending down and in the latest release it ticked back up, igniting concerns that more needs to be done to curb inflation.

The Fed played a bit into the market’s fears by putting slight hawkishness into its usual ambiguous commentary.

However, I still think a June cut is the most likely outcome due to:

1. Headline CPI numbers are inflated relative to true inflation
2. The Fed’s commentary could simply be use of their third lever.

True inflation is significantly lower than headline

Here is the breakdown of inflation as presented by the Bureau of Labor Statistics.

The headline 3.2% is really a composite of each of the other factors which each have a weighting depending on what portion of consumer spending they represent.

Food and energy are often excluded when discussing inflation because their prices do not fluctuate with inflation so much as with the cycles of the particular commodities. Thus, they are seen as a noise factor.

The largest portion of the remaining buckets is shelter which is about a third of the weight toward overall CPI. Shelter inflation came in at 5.7% which, due to its high weighting, materially pulled up the overall inflation number.

This 5.7% figure is a product of the extremely delayed way in which it is measured. Here is how the BLS describes the measurement:

“The rent component of the official CPI measures the change in all rents, including new leases, renewals, and rents in the middle of a lease.”

Renewals tend to almost always be roll-ups from the initial rent because the landlord knows the tenant would incur significant moving costs if they were to vacate. Thus, the renewals can be as much as a few hundred dollars a month above asking rents. The spread between asking rents and renewals is particularly wide right now.

Data on this is readily available, with Apartment REITs providing it in their earnings releases. Camden Property Trust (CPT), as a large cap apartment owner, represents a massive sample size, and here is their data.

New leases signed are down 4.3%.

However, since the BLS data is looking at renewals in addition to leases still under contract, it is primarily measuring what happened 6 months to a year ago rather than what is happening right now. Thus, the BLS data still shows this.

Just to illustrate that CPT’s data is not anomalous, here is the national data from Apartments.com.

Rents are factually about flat.

They were up about 5.7% a year ago which is what is showing in the inflation data, but that is not relevant to today’s inflation.

Another key piece of data that the Fed looks at with regard to shelter inflation is homeowner’s equivalent rent.

Homeowners equivalent rent is also delayed

FRED data shows homeowners equivalent rent continuing to chug upward through January.

However, actual home prices really only spiked through Mid-2022 and have been bouncing around since resulting in net fairly flat prices.

Thus, our conclusion is that headline inflation looked substantially higher than it is because the shelter component which is a heavy weight at 32% came in at 5.7% when the actual shelter costs are about flat.

Correcting for the delay in shelter reads, actual inflation looks much closer to the Fed’s 2% target which paves the way for a cut in June.

What about wages?

Sticky wage inflation is also a concern as it can be a driver of longer term inflation. Jay Powell (Fed Chair) has mentioned many times that he watches this factor closely.

BLS numbers show that wage inflation is coming down, but remains somewhat high at about 5%.

Wage growth in itself does not represent inflation as it is only part of the equation. If a worker produces twice as much and gets paid twice as much that would be inflation of 0%. In other words, the labor input cost of production would be unchanged.

Thus, wage growth should be compared to productivity growth shown in the chart below.

There are 2 big events distorting the chart above.

1. Laying off of low wage workers during the pandemic
2. Rehiring of low wage workers in late 2021 and early 2022.

Low wage and part time workers on average produce less per hour so the events above caused average productivity to spike in the pandemic and come down as those workers got rehired.

On a same worker basis, which is how wages are measured, productivity has risen quite nicely in the past few years. Once we net out the productivity increase, wage inflation looks well within healthy bounds.

With the above adjustments I believe inflation is looking fairly tame, which should allow the Fed to cut. The remaining sticking point is the Fed’s hawkish rhetoric.

Jawboning?

So the Fed has 2 main tools with which to influence the economy.

1. Changes to the Fed Funds rate
2. Quantitative easing or tightening.

These are fairly blunt instruments with very delayed impacts. As such, the Fed often implements its 3^rd unofficial tool:

1. Jawboning.

Merely commenting on the economy or the Fed’s future plans can cause reactions which actually impact the economy. Unlike its other tools, jawboning has immediate results as seen in the spike in the 10 year Treasury yield whenever Powell says hawkish things.

As this tool is faster and less committal it would make sense for the Fed to use it to fine tune its policy.

I am confident that Powell and the rest of the Fed already fully understand the intricacies and delays in CPI and wages that we have discussed in this article. It is, however, at their discretion as to whether they want to discuss their understanding of the delays in CPI.

The headline numbers still being somewhat cautionary give the Fed cover to jawbone a last little bit of tightness into the economy which provides extra surety that cutting will not reignite inflation.

Whether or not that is what they are doing is anyone’s guess. I think they are, but I can’t read Powell’s mind. The point here is that Hawkish rhetoric does not necessarily lead to hawkish policy. It could be jawboning to set up for more neutral or even dovish policy.

Interest rates are notoriously hard to predict, but the underlying subtleties of the CPI data suggest to me that a June or July cut is quite likely.