The Cool Down in July’s US Inflation Data

In what now seems like a monthly ritual, financial publications we follow globally spilled a ton of ink on the US’s July Consumer Price Index (CPI) report last week. (CPI is a government-produced broad measure of consumer prices across the economy.) It showed the headline inflation rate remaining at 5.4% y/y, leading a number of outlets to bemoan inflation’s apparently digging its heels in.^[i] Other outlets we follow noted month-over-month price gains slowed to 0.5% from June’s 0.9%, acknowledging recent hot inflation rates seemed to be moderating.^[ii] Yet many still seemingly went fishing for reasons to argue American consumer price trends are a long way from normal. In the UK and Europe, where reopening happened later than in the US, many financial commentators we follow portray the US’s experience as a harbinger of bad things to come on their side of the Atlantic. Yet in our view, the latest data have some encouraging takeaways. We do still see some signs of post-lockdown weirdness in the data, but in some ways, trends already appear to be back at normal. We think equity and fixed interest markets likely saw this coming months ago, but perhaps a quick look at the data will help you have more confidence that rising share prices and falling long-term interest rates haven’t been wrong.

Last month we highlighted the major categories driving June’s big consumer price increase: food, energy, hotels, used autos and transportation services. The first three of those remained sizable contributors to US CPI’s month-over-month increase in July, rising 0.7% m/m, 1.6% and 6.8%, respectively.^[iii] Used auto prices stalled, however, decelerating sharply from June’s 10.5% m/m gallop to July’s 0.2% crawl.^[iv] Transportation services detracted, falling -1.1% m/m as auto rental prices fell -4.6%, auto insurance slipped -2.8% and airfares inched down -0.1%. All of these figures suggest the surge of pent-up demand following the removal of America’s lockdowns is still affecting travel-related items, whilst shipping headaches still appear to be hindering the food supply chain and driving prices up. Yet we think the auto-related hiccups appear to be evening out, as July’s data suggest rental companies have largely finished rebuilding their fleets, allowing them to slash fares and cease contributing to the upturn in used auto prices.

What really jumped out at us in July’s report was the shelter component, which rose 0.4% m/m and contributed over one-fourth of CPI’s monthly rise.^[v] Hotels contributed about half of that. The other half came from rent. Not rent of primary residences, which is what we imagine most people actually think of when they think of rent. That figure rose 0.2% m/m, and it is only 7.6% of the total CPI basket, making its impact on headline inflation negligible in July.^[vi] The real culprit: Owners’ equivalent rent (OER), which rose 0.3% m/m and is a whopping 23.6% of the CPI basket.^[vii] Owners’ equivalent rent isn’t real—it is the hypothetical amount homeowners would pay to rent their own home, if they rented instead of owning it. Yes, you read that right, nearly one-fourth of the CPI basket is imaginary. It is not something anyone ever pays. It is instead a crude stand-in for home prices, which are an investment, not a capital good, and therefore excluded from CPI. We will leave it to you whether it is sensible to put this made-up service in CPI, but it is there nonetheless.

When seeing how much of the CPI basket OER accounts for, you might logically ask: What does inflation look like if you strip that out? Lucky for you, the fine people at America’s Bureau of Labor Statistics (BLS), which publishes CPI, have a “special aggregate index” called “All Items Less Shelter.” It rose 0.5% m/m in July, down significantly from 1.1% in June.^[viii] That 0.5% is much closer to the long-term average since data begin in 1940, which is 0.3%—and we think post-lockdown weirdness likely explains the remaining gap. A second special index, “All Items Less Food, Shelter and Energy,” slowed below 1% m/m for the first time since April, which happens to be the month that CPI inflation surged and seemingly set off many financial commentators’ alarm bells.^[ix] It rose just 0.3% m/m, matching its long-term average since data begin in 1967.^[x]

That seems … normal? We aren’t dismissing the lingering pandemic weirdness in travel, food and energy. Of course, July is also just one month—trends take time to develop. But we think trends in services prices provide another way to see it. Services, which comprise 61.5% of the CPI basket, saw aggregate prices rise just 0.3% m/m, below the long-term average (0.4% since 1956).^[xi] That is even with the OER weirdness and lingering hotel price increases factored in. So whilst pandemic-related hiccups are still affecting supply and prices, the data show this is largely confined to the universe of stuff, which also happens to be a minority share of GDP in the US and UK alike.^[xii] Said differently, the majority of the US economy didn’t experience unusual inflation in July.

In our view, that is likely an encouraging preview of how prices will trend in the UK and Europe over the next few months. These areas reopened later than America, so the impact of pent-up demand on prices is likely only just starting to emerge. America’s experience strongly suggests that effect is likely to be temporary.

Our research indicates inflation doesn’t have a preset equity market impact, so in our view, none of this is inherently good or bad for shares. But we still see plenty of headlines alleging markets are somehow overlooking various risks, inflation chief amongst them—a statement that we think severely misunderstands how efficient markets work. In our view, they aren’t ignoring anything. They are just better at analysing data than most financial commentators seem to be. In our view, they saw inflation trending toward normal months ago and acted accordingly.