To See March Inflation Clearly, Get Beyond the Base

Not good enough! That about sums up the common reaction to the March Consumer Price Index (CPI) inflation report, released Wednesday. Yes, the 5.0% year-over-year inflation rate was down big from February’s 6.0% and June 2022’s 9.1% peak.^[i] Yes, it was the slowest since May 2021. But core inflation, which excludes food and energy, was stubborn at 5.6%, a measly percentage point below its September 2022 high.^[ii] This, despite several rounds of big Fed hikes. Accordingly, headlines argue it is increasingly in doubt that we can get tame inflation without a recession. That “soft landing” everyone seemed to think likely just two months ago? Out the window. In our view, it is all too hasty. Strip out the base effect, and inflation has already eased close to pre-pandemic rates. The potential for positive surprise for stocks seems far greater than the chance of a negative shock.

When we talk about the base effect, we are referring to the reference point in the year-over-year calculation. To calculate that inflation rate, the Labor Department’s statisticians divide the current price level by the price level in the same month a year ago, then convert it to a percentage. That same month a year ago is the base. In the wake of big, fast inflation swings, that base can add considerable skew.

It is doing so today. March 2022 is when the temporary price dislocations from Russia’s Ukraine invasion started showing up in the inflation data. That effect ran through June, meaning it will be a few months more before the year-over-year rate incorporates the bulk of 2022’s CPI base. Prices today are still comparing to a world before energy and food prices and shipping costs peaked. Before supply chain disruptions started improving in earnest. Until all of that enters the base, the recent lower month-over-month rates won’t translate to a year-over-year rate that looks more historically normal.

But there are ways to compensate for this. One approach we find helpful: Using the seasonally adjusted monthly indexes to compute the annualized rates over, say, the last three and six months. Basically, that means converting the total price increases over the previous three and six months to annual rates. We do this in Exhibit 1, taking the calculation back to 2018 to show pre-pandemic trends. As you will see, headline inflation rates are nearly back to the old normal when you annualize the past three and six months.

Exhibit 1: Annualized Headline Inflation Rates

Source: FactSet, as of 4/12/2023.

Yah, but that is just because energy prices are down. Fair enough, and we will look at core inflation momentarily. But energy costs were a huge inflation driver, so their reversal is a very encouraging development.

As for annualized core inflation rates, they have also eased, but they are farther above pre-pandemic rates.

Exhibit 2: Annualized Core Inflation Rates

Source: FactSet, as of 4/12/2023.

There is a simple culprit for this: shelter. Rent and owner’s equivalent rent (OER) (basically the hypothetical amount homeowners would pay to rent their own house) comprise about one-third of the headline CPI basket and over 40% of core CPI. That is a huuuuuuuuuuuge weighting. Rents surged post-pandemic as home demand boomed amid tight supply (an after-effect of pandemic construction stoppages). OER also jumped with surging home prices. But residential real estate has cooled tremendously, and home prices have started rolling over in many locales. Given rent tends to follow at a 15-month or so lag, this suggests the shelter component of CPI should stop skewing core inflation higher pretty soon.

That will make the improvement in the non-shelter parts of core inflation much more apparent. Exhibit 3 shows the 3- and 6-month annualized inflation rates for the Labor Department’s CPI Ex. Food, Energy and Shelter (or, if you prefer, Core Ex. Shelter). These are pretty much smack dab in line with pre-pandemic norms.

Exhibit 3: Annualized Core Inflation Rates Excluding Shelter

Source: FactSet, as of 4/12/2023.

The point here is this: Inflation is about prices across the entire economy. Not select subsets, or in the case of OER, contrived calculations designed to approximate prices. So that easing in headline rates and core rates outside shelter is vital.

In time, these trends should be more visible in the year-over-year rates. It may take a few months, but we should get there. That means we probably have a few months more of stealthy improvement flying under the radar, obscured by persistent inflation fear. For stocks, we think this is a good thing. Positive surprise is what drives bull markets—reality quietly exceeding expectations. That is how markets climb the proverbial wall of worry. In our view, stocks still have some inflation bricks to climb.