Today’s inflation report came in at 8.5% which was slightly below the 8.7% that the market expected. The thinking is that now that inflation has come down from the 9.1% from last month and was below the expected number, we’re closer to Federal Reserve rate cuts and that’s why the market was up today. We’re not so sure this is the fantastic news others seem to think it is.
CPI Still Understated:
First, we’ve been saying for months that the CPI is understated. Food at up 11% is starting to more closely reflect reality but is still probably understated only because of substitution. Consumers are shifting from expensive beef to cheaper chicken leading to smaller increases in beef prices and higher inflation in chicken.
The shelter (housing) number (up 5.7%) is routinely understated due to the systematic under-counting caused when the U.S. Bureau of Labor Statistics starting using Owners Equivalent Rent instead of housing costs. The Zillow rental index was up 15% and the Case-Shiller index was up 20% (but lags by a few months). We’ve said all along that Fed rate hikes would work and would reduce housing prices; however, right now the market is locked up with a wide bid/offer spread between buyers who can’t afford high housing prices combined with higher interest rates and sellers who want last year’s prices. It’s important to note that typical rental contracts reprice once a year so the 15% – 20% housing increases are going to make their way through the system slowly. That means that while the CPI continues to under-state the cost of shelter, coming rent increases are going to mean that prices keep rising.
Adjusting for all of this, we think that actual inflation is now in the low/mid teens and is lower than a month ago. While the market may be happy with 8.5%, we note that over a 40 year working life, 8.5% inflation causes a loss of 96% of purchasing power. In addition, the real interest rate (Fed Funds rate less inflation) is negative, and real earnings growth is negative. So, we’re not convinced that rate decreases are around the corner.
Finally, the main reason that the CPI was below last month was the decline in energy prices. Fuel is still far above the price from last year, but is down a bit from last month. We’re not convinced this is sustainable. The White House has been draining the Strategic Petroleum Reserve (SPR) to get gas prices down ahead of the election. That’s intended to be used for emergencies. It looks like they have enough to get through the midterms unless we have a hurricane this fall that takes out refining capacity. Then, they’re going to have to refill the SPR at market prices. This is temporary relief, not new oil supply. In addition, we’ve read that Saudi Arabia is pumping at unsustainable levels and that even without a disaster, some fields are going to need to run at lower capacity for maintenance. We’ve also read that the Saudis are tapping their own version of the SPR and providing the market previously pumped oil out of storage. We have no way to verify this, but if true, it means that between the US SPR, temporary Saudi overproduction, and the possible release of Saudi reserves, the recent decline in oil prices might be unsustainable.
We’ll continue to monitor the situation and keep you updated.