Skeptics and the Slowing US Consumer Price Index

April’s US Consumer Price Index (CPI) inflation data hit the wires Wednesday, showing the pace of rising prices continued to ebb last month. Headline inflation slowed to 4.9% y/y, the first sub-5% reading since April 2021.^[i] Core inflation, which excludes volatile food and energy prices, eased from 5.6% y/y to 5.5%, continuing its 2023 holding pattern.^[ii] In reading all the news coverage, we found the reaction to be rather split. Some pundits cheered the slowdown and the Fed wiggle room it supposedly creates. Others counseled pessimism, warning inflation expectations are too high for inflation to continue easing to more historically normal levels. We think it is all part and parcel of stocks climbing a wall of worry in a new bull market.

The report itself showed many of shoppers’ recent sore spots are starting to heal. Food prices, which peaked at 11.4% y/y last August, decelerated again from 8.5% in March to 7.7%.^[iii] Energy prices remained in deflation at -5.1% y/y. Shelter (primarily rent and owner’s equivalent rent, OER, which is imaginary) prices remained elevated year-over-year at 8.1%, but they decelerated to 0.4% m/m, the slowest increase since January 2022. As weak housing prices start filtering more into OER and rents, the shelter component should moderate further still. That should make the easing services inflation outside shelter, which we detailed last month, more apparent.

Notwithstanding last year, there is no meaningful long-term relationship between stocks and inflation trends. Stocks have done fine in periods of accelerating and slowing inflation alike, and they have risen alongside elevated inflation rates before. We have also had bear markets coincide with fast and slow inflation. So we don’t think slowing inflation now is some massively bullish driver. However, inflation fears were a major contributor to last year’s bear market, along with the Fed U-turn and rate hike fears they spawned. As improvement now and from here eases those fears, it should be a tailwind to some extent, although the effect should diminish as it gets more widely seen and therefore priced in.

Yet we don’t think this hinges on the Fed pausing its rate hikes or even being able to cut soon, as so many alleged Wednesday. That, too, ascribes too much market-moving power to the Fed, ignoring that stocks have risen through several big rate hikes now, as we showed last week. Moreover, markets have already priced in diminished Fed activity. This time last year, investors projected several percentage points’ worth of hikes. Now, expectations are minimal, and people’s senses have mostly dulled. After successive 0.75 percentage point hikes, a quarter point or so more largely feels like a pause. As for potential rate cuts, conventional don’t fight the Fed wisdom says they would be bullish. But consider also that if the Fed were to cut, everyone would probably start worrying that central bankers see mounting economic risks. We reckon many would point out that the Fed typically doesn’t start cutting until well into recession, and doing so during an expansion just because they can is a very rare thing. Besides, considering rate hikes haven’t deterred economic growth, it seems illogical to say good times from here hinge on cuts. So here, too, we see room for sentiment to improve.

The inflation expectations angle also indicates dug-in pessimism. The argument: While inflation may be slowing, expectations—which become a self-fulfilling prophecy—are too high. Yes, Nobel laureate Milton Friedman may have made a glorious career showing inflation is a monetary phenomenon of too much money chasing too few goods, but it is now trendy to view it as a psychological phenomenon. If businesses think inflation will be high, they will set prices accordingly. If consumers think inflation will be high, they will pay higher prices. Hence, according to one article, it is bad news that a U-Michigan survey shows consumer inflation expectations exceeding 4% for two years and a separate survey shows businesses anticipate inflation topping 5% over the next year.^[iv] Sure, market-based indicators show investors expect inflation just north of 2% over the next 5 and 10 years, but what if near-term expectations are a more powerful force?^[v] Egad!

The case for inflation expectations mattering mostly stems from Japan, where policymakers seemingly used it as a cover when monetary policy mistakes and distortions from megabank (and massive government bond buyer) Japan Post flattened the yield curve, tamping money supply growth and weighing on prices. If only people could just get in an inflationary mindset, they argued, they would start buying more and driving prices higher rather than waiting indefinitely for tomorrow’s bargains. That mentality spread globally, and if we had a nickel for every central banker who talked about “well-anchored inflation expectations” over the past 15 years, we would have … well probably several dollars, but you get it. It happened a lot.

In our view, this has no logical underpinning. It ignores the quantity theory of money, which has well over 100 years of analysis and data supporting it. If the amount of money doubled while the supply of goods and services stayed fixed, prices would likely jump until supply and demand returned to balance. Conversely, if the quantity of money stayed stagnant while output doubled, everything would likely get cheaper until, yes, supply and demand intersected. This is dry Econ 101 stuff, and we are sorry if that is triggering, but it has also proven true again and again. It has nothing to do with psychology and everything to do with how the amount of money at consumers’ and businesses’ disposal squares with how much the economy can produce. If this weren’t true, and inflation expectations mattered, then inflation would never fluctuate, because expectations are always based on the recent past. That is just recency bias at work.

But hey, if the inflation expectations myth stays alive—and promotes pessimism—then bully. It further extends the inflation wall of worry, preserving surprise power. It may not sound like much, but reality beating grim expectations is the driving force of every new bull market, and we think the rally since last October 12’s low looks increasingly like one. So be thankful for the skeptics and yah-buts. They are laying the groundwork for stocks to keep rising, in our view.