As Winter Wanes, Prices Continue to Cool

What will the Fed do next week? That is the million dollar question for many. As recent economic data beat expectations, many presumed the Fed would have to raise rates higher for longer to quell inflation. But then came the collapse of Silicon Valley Bank, and as Fisher Investments Founder and Executive Chairman Ken Fisher has said, the only thing the Fed hates more than inflation is a banking crisis. So speculation soon shifted that the Fed will stand pat or hike by just a quarter point. As ever, we think that is unknowable—Fed decisions always are. However, today’s February inflation report shows prices are cooling regardless, which should help continue easing one of the big fears contributing to last year’s bear market.

The headline Consumer Price Index (CPI) slowed to 6.0% y/y, the slowest rate since September 2021.^[i] Much of the easing came from energy prices, but “core” CPI—which excludes food and energy—slowed from 5.6% y/y in January to 5.5%.^[ii] This improvement came as month-over-month headline CPI slowed just slightly, from 0.5% to 0.4%, and core CPI sped from 0.4% to 0.5%. This is your clue that the year-over-year figures are skewed from the base effect—that is, from price movements a year ago. February 2022, after all, is when energy and raw materials prices spiked in the run up to—and immediate aftermath of—Vladimir Putin’s Ukraine invasion. That bumped February 2022’s inflation rate to 7.9% y/y, and that higher price level is now the denominator in February 2023’s year-over-year rate. When the denominator jumps faster than the numerator, you get a smaller rate.

That isn’t to pooh-pooh February 2023’s improvement, but rather to ensure we are looking at the data objectively. The base effect will probably continue promoting slower annual rates for the foreseeable future, as inflation continued accelerating through June 2022. Yet month-over-month rates are also easing under the hood. The core rate got a lot of attention today as evidence that inflation is supposedly stubborn and sticky. But shelter costs—rent and owner’s equivalent rent—were the primary contributor there. They rose 0.8% m/m and represent 34% of total CPI—and over half of services CPI.^[iii] That isn’t great for people trying to find affordable housing, but, crucially, it is a lagging indicator, typically lagging home prices by about 15 months. Given the well-documented weakening in residential real estate markets, it should be only a matter of time before the shelter component of CPI eases.

Meanwhile, outside shelter, there wasn’t much monthly inflation to speak of. Core goods prices—goods excluding food and energy—were flat month-over-month. Excluding shelter, services prices rose just 0.1% m/m.^[iv] Yes, those figures gloss over divergence among the included categories—some jumped, some fell. But this isn’t unusual. At any point, category-specific supply and demand trends will cause prices to rise in some pockets and fall in others. Inflation refers to aggregate price trends across the broad economy—how all the extremes average out. These days, shelter aside, they are averaging out to marked disinflation.

To us, this is good news. We think it shows economic developments thus far are happening despite the Fed, not because of it. The Fed influences economic growth insofar as its interest rate moves influence loan growth. Since banks haven’t had to pass Fed rate hikes onto depositors to compete for business thus far, their net interest margins have widened—borrowing short and lending long is more profitable, supporting fast loan growth. That has helped GDP grow despite rate hikes. Meanwhile, supply-side inflation factors have improved—and money supply has slowed significantly despite fast loan growth—helping prices ease. In other words, the Fed just doesn’t have the amount of economic control most people ascribe to it, but inflation is cooling anyway.

Therefore, whether or not the Fed raises rates next week, we don’t think it should matter much to prices looking forward. Now, the caveat to all of this is that it isn’t yet clear how the Silicon Valley Bank saga—which we will have more commentary on for you later this week—will affect loan growth and how much banks pay for deposits. It will take a few weeks for this to start showing in the data, so we will be watching closely. But it also seems highly unlikely that banking crisis fears would trigger much faster inflation, as they add incentives for banks to reduce risk. And notwithstanding the potential for regional banking wobbles to stoke more short-term volatility, we think continued improvement on the inflation front is likely to keep helping sentiment throughout this year, even if that happens in fits and starts.