Our Counsel After April’s CPI Slowdown

Editors’ Note: Inflation is an increasingly politicized topic on both sides of the American political aisle. However, our look is focused on the data and what we think investors should glean—or not glean—from it.

April’s consumer price index (CPI) inflation data hit the wires Wednesday, and for the second month in a row, pundits seemed united in a quest to find signs inflation has peaked. At first blush, the headline rate’s deceleration from 8.5% y/y in March to 8.3% in April may seem to confirm that view.^[i] Ditto for the month-over-month rate’s slowing from 1.2% to 0.3%.^[ii] We would love it if prices were really, truly offering American households some relief, and we do expect inflation to moderate as the year progresses. But this effort to pinpoint the start seems counterproductive to us. Markets aren’t myopic, and such inflection points will be clear only in hindsight anyway. In our view, keeping realistic expectations and a long-term perspective will be key to navigating the period ahead.

We say this because we can envision a world where April’s slight deceleration creates expectations that the worst is behind us. Pundits’ focus on the three-month slide in used car prices—which were a big inflation driver last year—and the steep drop in energy prices could also add to this. Meanwhile, national average gas prices hit a record-high $4.40 per gallon today, suggesting some energy prices will resume contributing positively to the inflation rate.^[iii] Other supply chain issues, like the ongoing baby formula shortage that helped drive baby food prices up 3.0% m/m in April, could be a contributing factor again in May.^[iv] We can see a risk that investors get too caught up in a the worst is over mindset and get blindsided if inflation remains stubbornly high, raising the temptation for knee-jerk portfolio moves. Four-plus months into a correction (sharp, sentiment-fueled drop of -10% to -20%), reacting to bad headlines is one of the most dangerous moves an investor can make.

So, let us offer some realism. Not pessimism—again, we still think inflation is likely to decelerate over the foreseeable future. But we also think it is impossible to know when and how high the inflation rate will peak. Note that while headline inflation decelerated in April, that was due almost entirely to what appears to be a pullback from extremely hot March energy prices. “Core” inflation, which omits food and energy, may have decelerated from 6.5% y/y in March to 6.2% y/y in April, but this seems due primarily to the base effect.^[v] April 2021 is when inflation really got cooking as the prior winter’s lockdowns eased, raising the comparison point for the year-over-year calculation. Core prices rose 0.9% m/m that month. In April 2022, they accelerated from March’s 0.3% m/m to 0.6%. The base just rose more, creating a slower year-over-year rate. A more meaningful drop in the core inflation rate would be if the base effect and slower month-over-month price increases collided. That hasn’t happened yet.

Whether it happens in May, June, July or later is impossible to say. There are too many moving parts. The base effect will become an increasingly greater factor as we move through the year, especially once higher energy prices enter the denominator this autumn. But month-over-month changes are also fickle. Additionally, there was a noteworthy shift in April as services prices replaced goods as the main accelerant—a seemingly logical consequence of demand for travel and leisure services far outstripping supply. That could last through the summer travel boom. Service providers may not be through passing their cost increases to consumers. This could take time to work its way through our very large and decentralized economy.

Crucially, though, pain for households often doesn’t translate to pain for markets. Yes, stocks have seemingly reacted to inflation at times this year, but we think they are reacting to the fear, not prices themselves at a fundamental level. Perversely, rising consumer prices can actually be a positive signal for corporate earnings, which are what all stock investors own a stake in. They mean the market can bear it when companies charge more, which helps them preserve profit margins as their costs rise. In our view, this is a big reason why stocks have often risen through periods of above-average inflation, not hitting trouble until the Fed overshoots when trying to rein in prices. Earnings are similarly resilient this time: With over 90% of companies reporting, FactSet estimates S&P 500 earnings rose 9.1% y/y in Q1, driven by a 13.4% rise in revenues.^[vi] Fear holds sway over markets for now, but in time stocks should resume weighing fundamentals. Those look rather strong.

As for the Fed, pundits also spilled countless pixels trying to divine what today’s report means for the path of rate hikes—always a fruitless endeavor, in our view, but especially today. Yes, a rate hike does look likely in the immediate future, based on all the Fed’s telegraphing thus far. But beyond that is far from clear, and the data today don’t help shed much light. The Fed doesn’t base monetary policy on CPI. Its preferred gauge is the headline Personal Consumption Expenditures (PCE) price index, which comes out toward the end of the month and is calculated rather differently. CPI and PCE have different category weights, and PCE also factors in the effect of substitution as consumers respond to price changes of individual goods and services. For instance, if they buy less gasoline as fuel prices rise, that shows up in real-time in the PCE basket. This is the main reason PCE comes out weeks after CPI—the census bureau can’t calculate it without consumer spending data. While CPI and PCE’s general trends often track each other, PCE tends to run lower.

Additionally, when the Fed next convenes it will have at least one new member. Lisa Cook just received a Senate confirmation vote yesterday. Philip Jefferson, who won the Senate Banking Committee’s vote at the same time as Cook, could win confirmation before mid-June’s meeting. Again, we doubt that sways things at the next meeting much given the current zeitgeist. But how one or two new voices will affect the consensus view on, say, summertime inflation data that aren’t out yet is unknowable.

At the same time, we don’t think near-term monetary policy moves are likely to be consequential. As we have detailed before, today’s price jumps stem from supply shortages, not monetary excess. Therefore, the Fed can’t do much about it with monetary tightening. If they keep trying anyway, they have plenty of bandwidth to do so without causing economic harm. The gap between 3-month and 10-year yields—the most meaningful segment of the yield curve, in our view—is presently over 2 percentage points.^[vii] That is a very long way from inverted.

So take a deep breath. Stocks have spent the past four-plus months pricing inflation fears, and expectations are quite low today. Once that fear works its way through, markets should resume weighing reality against those expectations, and it shouldn’t take much positive surprise to help fuel the strong bounce that usually follows corrections.