Disinflation’s Implications

The US consumer price index (CPI) fell -0.1% m/m in June, its first monthly decline in four years, drawing heaps of headlines—and immediate speculation on what this means for Fed policy, the economy and stocks.^[i] While inflation’s continued cooling is welcome, we think this is old news for markets, which spied disinflationary trends long ago.

Driving the headline decline: gasoline prices’ -3.8% m/m drop, helped by used cars (-1.5%) and air fares (-5.0%).^[ii] More broadly, goods prices have flipped negative recently while services prices are generally decelerating. Exhibit 1 shows goods prices fell -0.4% m/m for a second straight month and have seesawed for over a year after the historically unusual, consistent (and sharp) climb during 2021 – 2022’s supply chain chaos. But most striking to us: services inflation’s slide from 0.7% m/m at 2024’s start to 0.1% midyear.

Exhibit 1: Monthly Goods and Services CPI Swings Back to Prepandemic Norms

Source: FactSet, as of 7/11/2024.

Many blame continually rising services prices for stubbornly high inflation, but the trend all year has cut against the popular narrative when we look at the data on a monthly basis. Conventional wisdom claims services make a better gauge of underlying inflation than goods because they cover the lion’s share of economic activity, and services prices tend to be steadier. Fair enough. But 42% of services prices consist of owners’ equivalent rents (OER), a hypothetical figure estimating what homeowners would pay to rent their own homes.^[iii] No one pays this, and its inclusion is questionable logically, considering homes are an investment and payments don’t fluctuate month-to-month. Imaginary prices may be “stickier,” but that doesn’t make them a truer measure of inflation.

Now, services excluding shelter (mostly OER) accelerated from 3.0% y/y last October to 5.0% in May, before easing somewhat to June’s 4.8%.^[iv] But that doesn’t mean the inflationary beast got back out of the cage. It stems primarily from early-year increases in transportation services and medical care costs. Both have since eased, and they represent industry quirks more than a broad phenomenon of too much money chasing too few goods and services. Note, too, that while services prices are less sensitive to supply factors, this portion of CPI isn’t inherently more real or meaningful than falling goods prices, which have largely offset rising services’ (ex. shelter). There will always be sections of the consumer basket that are rising or falling. What matters—for the prices people pay and for inflation across the broad economy—is how those moving parts come together as a whole.

To see how these monthly moves translate to overall improvement in CPI’s annual rates, ex. shelter, see Exhibit 2. Headline CPI decelerated to 3.0% y/y from May’s 3.3%, while core CPI (excluding food and energy) ticked down to 3.3%, its slowest since April 2021.^[v] But we think that gives a skewed version of inflation given the biggest force propping CPI up in June was shelter, which rose 5.2% y/y. These prices combine actual rent payments and OER. Strip this out and you see something stark: Excluding shelter, CPI rose just 1.8% y/y in June.

Exhibit 2: CPI Ex. Shelter Below 2%—and Shelter Trending Down

Source: FactSet, as of 7/11/2024.

Meanwhile, there is likely more headline (and core) CPI slowing ahead. OER tends to lag actual home prices by around 15 months. This means further deceleration is likely baked in from housing costs’ slight year-over-year dip negative last year.

Inflation’s reality has long been better than perceived. CPI inflation excluding largely made-up shelter costs has mostly been below 2% since June 2023. While some only see this now, markets did so long ago. Inflation’s 2022 spike contributed to that year’s bear market (fundamentally driven decline exceeding -20%), but the bull market that began October 2022 occurred with CPI still rising around 8% y/y—when headlines were frightful. We think forward-looking stocks in part pre-priced the improvement and gradually easing fear that was to come, which we are seeing today.

Now, most chatter surrounding June’s inflation report focuses on its prospects for Fed rate cuts. Markets are pricing in a series of quarter point reductions starting September. But don’t overrate rates, as they don’t drive stocks. To see this, consider: Rate cut expectations have been all over the place this year, ranging from five to seven as the most likely scenario in Q1 to just one to two cuts now. Yet stocks have been relatively calm amid this year’s strong first half regardless. Maybe cuts provide some aid for rate-sensitive areas like real estate, but the broader market doesn’t seem to hinge on them.

Inflation has been a major economic and financial story for almost three years now and its return to normal is a nice development. But this isn’t surprising to markets, which lead, anticipating economic developments well in advance of headlines.