INSIGHTS

On February 21, 2023

The Long Road to 2% Inflation

After three soft inflation prints in a row, the Consumer Price Index (CPI) report provided a reminder that the path to the Federal Reserve’s (Fed) 2% target is still some way away.

Headline and core CPI were both in line with expectations at 0.5% and 0.4% month-over-month, respectively, (from 0.1% and 0.4%) or 6.4% and 5.6% year-over-year.

There were relatively few negative contributors across the index on a month-over-month basis, with the most notable exceptions included in Table 1 below. Services inflation once again led the way, followed by energy (which rebounded), while goods disinflation slowed.

Table 1: Shelter prices and energy inflation led the way

Source: Bureau of Labor Statistics, February 2023

Core CPI has been somewhat persistent despite favorable base effects

As we highlighted previously, inflation still looks likely to fall over the first half of 2023, mainly due to favorable base effects, but this tailwind could potentially run out in June.

If we project the six-month monthly average forward to illustrate base effects, we see headline CPI continuing to make significant progress lower, but core inflation may be at greater risk of stabilizing by the summer, given the potential persistence of the index’s less volatile components (Figure 1). As such, it may need more than base effects to bring CPI sustainably closer to target.

Figure 1: Core CPI may prove stubborn even as headline CPI rides base effects down

Source: Bureau of Labor Statistics, FRED, Insight calculations, February 2023

Services CPI still going strong

Of these stubborn core CPI components, Fed chair Powell has been closely watching services CPI, particularly core services excluding shelter. The measure (shown by the light blue bars in Figure 2), accelerated this month, offering little comfort to the Fed.

Figure 2: Services inflation continued to be the Fed’s greatest challenge

Source: Bureau of Labor Statistics, FRED, Insight calculations, February 2023

Nonetheless, the descent in shelter inflation could potentially be painfully slow. The Bureau of Labor Statistics (BLS) measures rents through samples that are only refreshed every six months. This means that, as underlying prices change, they filter into the data gradually. Shelter inflation may remain high for some time before slowing later in the year.

Medical services are the other major services category. It is no surprise to us to see it resume a downward trajectory, given a persistent drag from medical insurance which we expect to continue into October.

Energy provides an uplift to inflation

Energy continues to be a highly volatile component of the index. Last month it was the largest negative contributor to headline CPI, while this month it is the second highest after shelter, contributing 0.17%.

Energy prices saw a boost during January. A significant factor was unusually cold weather in California which appeared to offset relatively warm weather on the East Coast. Daily gasoline prices also rose 8.9% in January, albeit remained 30% below last year’s peak.

Volatility continued. So far in February, energy prices have started falling again as weather normalized. Geopolitics will likely continue to be a driver over the longer term as China reopens and developments in the Russia/Ukraine war continue to impact the market. At the current pace, however, energy is likely to set to retrace its gains next month.

Core goods disinflation could be set to slow down

Disinflation in goods remains a longer-term theme, with core goods prices up only 1.3% year-over-year, the lowest since February 2021. However, month-over-month core goods rose slightly at 0.07%, the fastest since September, mainly on advances in apparel and new cars, indicating this trend could be slowing down.

On the negative side, used cars were once again the largest negative contributor to the index, falling 1.9% and contributing -0.07%. However, this category is potentially set to reverse course next month. Its leading indicator, the Manheim Used Vehicle index, rose 2.5% in January, the fastest since November 2011 (now 12.8% below its 2021 peak). Supply and demand imbalances are still playing out despite recent supply chain improvements, as indicated by the ratio of auto inventories to sales, which is still around all-time lows and has been a solid indicator of pricing (Figure 3).

Figure 3: Used cars were the worst performing category, but are set to reverse next month

Source: Mannheim, BLS, Insight calculations, February 2023

No market surprise despite methodology changes

Inflation was in line with expectations despite the added element of uncertainty. As this was the first CPI print reflecting 2023 data, there were some methodology changes.

The BLS provided its annual refresh of seasonal adjustments for the last 5-years of data. The notable impact was to revise up recent data, indicating disinflation is occurring at a slower pace than previously reported. For example, goods were reported to have fallen, at -0.1% month-over-month last month, but that print was revised up to 0.1% instead.

The BLS also improved the sampling methods for the shelter components of CPI to track a more representative mix of detached and non-detached houses. Secondly, it discontinued its “new vehicles” CPI series and replaced it with two series separately tracking new cars and new trucks, adding a data source to achieve this.

The BLS also refreshed the index weights, based on updated consumer expenditure data, which it will now do annually instead of biannually. Most notably in our view, core services rose from 56.5% to 58.1%, within this, while shelter’s weighting rose from 32.9% to 34.4% weight. Notably, energy’s weighting fell from 8.8% to 6.9%. On the margin, this could help headline and core CPI fall faster over the year if the shelter component begins to fall (as we expect it will).

No victory yet on inflation

CPI has continued to moderate, but it will be an uneven path towards the Fed’s target of a sustainable ~2% regime. We expect more progress on headline CPI until the summer, but progress in the stubborn Core CPI services categories (particularly non-shelter and non-medical) are the ones to watch. Once the Fed sees weakness there, it will be one step closer to declaring victory.

For now, we expect the Fed will continue to adopt a cautious tone, particularly given the excellent labor market data released earlier this month. The Fed also faces a communication challenge to keep financial conditions tight enough to reduce inflation in the services categories. As such, we expect the Fed to continue to guide toward more hiking activity.

CRN: 2023-0214-10666 R

The opinions and views of this commentary are that of Insight Investment and are not necessarily that of Advisors Asset Management. 

Any forecasts or opinions expressed herein are Insight Investment's own as of February 14, 2023 and are subject to change without notice. This information may contain, include or is based upon forward-looking statements. Past performance is not indicative of future results.

The Consumer Price Index (CPI) is released by the Bureau of Labor Statistics as a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.