CPI In-Line With Expectations: Great News For The Bulls

Inflation Increases Because Of Easy Comparisons

After the PPI-FD report beat estimates, some bulls were worried that the June CPI report would also beat estimates. The fact that it was mostly in line with estimates is a big win for the bulls because it means the Fed won’t raise rates a 5th time this year. Currently, there is a 52.9% chance the Fed raises rates 4 times in 2018 and a 2.7% chance it raises rates 5 times.

It seems very unlikely that a 5th hike will occur, but that chance would have been much higher if CPI beat the consensus. I think year over year inflation will be mitigated in Q4 by the tougher year over year comparisons. That could push the Fed closer to hiking 3 times, but obviously year over year comps aren’t the only factor which affects inflation.

Month over month CPI was up 0.1% which missed estimates for 0.2%. As you can see in the chart below, year over year headline CPI was up 2.9% which met the consensus estimate and was 0.1% higher than last month. The comparison was easy as you can see from the green arrow. CPI was only up 1.6% in June 2017. In September 2017, CPI was 2.2%, which means the comparison will get much tougher.

Core CPI was up 0.2% month over month which met estimates and was the same as last month. Core CPI was up 2.3% year over year which beat the consensus and last month’s report by 0.1%. The scaling in the chart below underrepresents the major change year over year comparisons will undergo in the next 9 months. June 2017 core CPI was up 1.7%. March 2018 core CPI was up 2.1%. Starting in January 2019, the comparisons will be tough. The easiest one is August which had 1.7% core inflation in 2017.

CPI Details

Let’s look at the specifics of the report. Medical expenses were up 0.4% month over month and 2.5% year over year. The chart below shows the month over month change in healthcare in the PPI and PCE reports. The PPI selected healthcare industries prices were negative, but less so than the previous report. The PCE healthcare services inflation was low in May. We will get the PCE report for June in 2.5 weeks. I expect core PCE inflation will be above the 2% target which was hit last month, but it won’t cause the Fed to act because of its symmetrical policy. Anything at 2.5% or higher would be disconcerting, but that’s highly unlikely to occur. Vehicle prices were up 0.4% and used vehicle prices were up 0.7%. This is near the PPI report’s numbers.

The most interesting part of this report is shelter inflation was modest. Housing inflation was unchanged because there was a 3.7% decline in away from home price. Owners’ equivalent rent was up 0.3%. The rental inflation component of the CPI index was 3.58% year over year which was the lowest since July 2015. The chart below shows the non seasonally adjusted shelter inflation. You can see a modest tick lower at the right end of the chart. There was some volatility in oil prices in June as that was the period leading up to the OPEC decision. This explains why energy prices were down 0.3%. This is why the month over month headline reading missed estimates. Food prices were up 0.2% month over month.

Margins Being Crimped

One key takeaway from this report is the PPI-FD inflation shows costs for businesses are increasing quickly, but the Consumer Price Index shows that inflation isn’t directly pressuring consumers as much. This implies business margins have compressed. Either the producers will increase prices for consumers which will hurt demand or margins will continue to be impacted. The tax cuts soften the blow, but this is a disconcerting trend.

TIPS Rate Shows Market Knows Inflation Isn’t Soaring

One bit of good news is the market based inflation metric, which is the TIPS breakeven rate, shows there aren’t expectations for inflation to increase further. As you can see from the chart below, the 5 year TIPS breakeven rate has been in a tight range for 6 months. The bottom end is about 1.95% and the top end of the range is about 2.18%. It’s now right in the middle of that range. The weakness in inflation expectations partially explains why the long bond yield hasn’t been able to increase further. In saying that the 10 year yield has likely peaked for the cycle, I’m primarily saying GDP growth won’t go up from the Q2 rate.

I also think inflation won’t get much higher this cycle than the year over year rates seen this summer. I think the bond market has already priced in the fact that these higher inflation prints in the next few months are mostly because of easy comparisons. The stock market is also reflecting this situation by compressing multiples. I believe the market will break the record high set in January if the trade war rhetoric is resolved, but even if it does so, returns will be much lower than earnings growth.

No Real Earnings Growth

Even though not all the inflation is being passed on to the consumer, it’s still terrible news for workers because real wage growth is near zero. Weekly earnings growth was 3% in June which means real earnings growth was 0.1%. Hourly earnings growth was only 2.7% which means real hourly wages were -0.2%. The chart below shows real wages from January 2015 to May 2018. As you can see, rising inflation has destroyed real wage growth. This is why it is so critical for nominal wage growth to accelerate quickly at the end of the cycle. It’s also why the Fed needs to hike rates even though accelerated nominal wage growth has just gotten started. The wage growth is meaningless if inflation picks up. Inflation isn’t even high, but wage growth is very disappointing.

 

 

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