‘Supercore’ Inflation Focus Isn’t Super Logical

Roses are red, violets are blue, inflation did slow, but is CPI true? This is how we would (unartfully) sum up headlines’ reaction to the Labor Department’s valentine to America, otherwise known as the January Consumer Price Index report. The headline inflation rate slowed to 6.4% y/y from December’s 6.5%, extending the slide from June’s 9.1% high.^[i] Core inflation, which excludes more volatile food and energy prices, eased to 5.6% y/y from 5.7%.^[ii] But given monthly CPI jumped from an upwardly revised 0.1% m/m to 0.5%, there wasn’t much cheer. Pundits also remained focused on various measures of “supercore” inflation—allegedly superior baskets that showed inflation is more entrenched than headline results suggest. To us, this indicates there remains room for sentiment to catch up to reality and bring stocks more inflation relief.

“Supercore” varies in the eye of the beholder. Some define it as services less energy services and shelter. Others leave out health insurance as well. Definition aside, all rest on the presumption that everyday services prices are “stickier” than goods since they are (allegedly) more sensitive to labor costs than supply chains and other external factors. Those who follow it presume wages drive prices—ignoring Milton Friedman’s powerful research and arguments to the contrary—arguing that if supercore prices remain jumpy, then a wage/price spiral must loom. The Fed is allegedly a fan, and Chairman Jerome Powell called it perhaps “the most important category for understanding the future evolution of core inflation.”^[iii] Fed officials often flip and flop around on what they say, so take that as you will.

Regardless, we don’t think this supercore theory is super logical. For one, core inflation doesn’t predict headline inflation. By definition, it can’t, since everything in core inflation is in headline. Prices don’t predict themselves. Nor do the items in core inflation predict the items that cause occasional divergence in headline inflation. Do shelter and clothing costs predict food prices? Do the costs of cosmetics, haircuts and sporting equipment predict gasoline? Heck no. Food prices move on—wait for it—supply and demand. Ditto energy prices.

Now, apply this same reasoning to core and supercore. The big item missing from supercore, which also happens to represent just over one-third of CPI and over half of services CPI, is shelter—rent and owners’ equivalent rent (OER), which is the hypothetical amount a homeowner would pay to rent their own house. An imaginary price, not a real one. Both tend to follow home prices, as pricey houses lift OER and raise demand for rental units, driving rents higher. That would seem to make home prices—not everything in supercore inflation—a better indicator of how core prices will evolve.

Even if supercore prices were predictive, we don’t think it would make sense to pin it on labor costs. Actually, it is the other way around: Inflation influences wages as it forces businesses to pay more to retain workers.^[iv] But pay takes a while to catch up, which is why real (inflation-adjusted) wages remain negative. Last year, the Labor Department’s Employment Cost Index rose just 4.9%, well behind CPI.^[v] The Atlanta Fed’s Wage Growth Tracker has also trailed CPI. So in a way, businesses actually had a little more breathing room on labor costs than other parts of their overhead, including rent, utilities, supplies, cleaning, security and other essentials. As all those prices ease, so should supercore prices. Meanwhile, given OER typically lags home prices by about 15 months, it should start slowing before long. Rents, too, have stabilized. Ditto for food and energy commodity prices. All point to easing inflation over the period ahead, in our view.

It won’t happen in a straight line, though, as January’s data show. Temporary bumps will happen, like the 2.4% m/m rise in gas prices—which followed several months of far larger declines—and a 6.7% jump in household natural gas prices.^[vi] The Ohio train derailment may cause similar dislocations by interrupting supply of key feedstocks (among its other effects, which we aren’t minimizing). Falling wholesale egg prices may take a while longer to filter through to supermarket shelves. Whenever the economy has to swallow a shortage or price bump, it can take a while to work its way through the whole system.

The heightened focus on supercore inflation misses this, in our view. It clings to backward-looking measures as confirmation that fast inflation is here to stay, which suggests sentiment is stuck on those higher rates. At some point, as even these measures show improvement, the supercore watchers will have to concede that things are getting better. As they do and relief sets in, it should extend the tailwind stocks have enjoyed from easing inflation dread. Now, we do think the bullish impact of slowing inflation will fade over time—and it probably has already begun to. It is increasingly a known factor. However, the supercore focus shows it isn’t spent yet. And that makes supercore fixation bullish. It keeps expectations low and the potential for positive surprise and falling uncertainty high—part of the nice wall of worry stocks ordinarily climb, in our view.