The Cool Down in July’s CPI Data

In what now seems like a monthly ritual, headlines went nuts for July’s Consumer Price Index report on Wednesday. It showed the headline inflation rate remaining at 5.4% y/y, leading a number of outlets to bemoan inflation’s apparently digging its heels in.^[i] Other outlets noted month-over-month price gains slowed to 0.5% from June’s 0.9%, acknowledging recent hot inflation rates seemed to be moderating.^[ii] Yet many still went fishing for reasons to argue we are a long way from “normal.” We do still see some signs of post-lockdown weirdness in the data, but in some ways, we are already back at normal. Stocks and bonds saw this coming months ago, but perhaps a quick look at the data will help you have more confidence that rising stocks and falling bond yields haven’t been wrong.

Last month we highlighted the major categories driving June’s big increase: food, energy, hotels, used cars and transportation services. The first three of those remained sizable contributors to CPI’s month-over-month increase in July, rising 0.7% m/m, 1.6% and 6.8%, respectively.^[iii] Used cars stalled^[iv], however, decelerating sharply from June’s 10.5% m/m gallop to July’s 0.2% crawl.^[v] Transportation services detracted, falling -1.1% m/m as car rental prices fell -4.6%, car insurance slipped -2.8% and airfares inched down -0.1%. So the surge of pent-up demand post-lockdown is still affecting travel-related items, and shipping headaches still appear to be hindering the food supply chain and driving prices up. Yet the auto-related hiccups appear to be evening out, as July’s data suggest rental car companies have largely finished rebuilding their fleets, allowing them to slash fares and cease contributing to the upturn in used car prices.

This month, what really jumped out at us was the shelter component, which rose 0.4% m/m and contributed over one-fourth of CPI’s monthly rise.^[vi] Hotels contributed about half of that. The other half came from rent. Not rent of primary residences, which is what you actually think of when you think of rent. That figure rose 0.2% m/m, and it is only 7.6% of the total CPI basket, making its impact on headline inflation negligible.^[vii] The real culprit: Owners’ equivalent rent (OER), which rose 0.3% m/m and is a whopping 23.6% of the CPI basket.^[viii] Yes, you read that right, nearly one-fourth of the CPI basket is imaginary. Owners’ equivalent rent isn’t real—it is the hypothetical amount homeowners would pay to rent their own home, if they rented instead of owning it. It is not something anyone ever pays. It is instead a crude stand-in for home prices, which are an investment, not a capital good, and therefore excluded from CPI. We will leave it to you whether it is sensible to put this made-up service in CPI, but it is there nonetheless.

When seeing how much of the CPI basket OER hogs, you might logically ask: What does inflation look like if you strip that out? Lucky for you, the fine folks at the BLS anticipated this question and have a “special aggregate index” called “All Items Less Shelter.” It rose 0.5% m/m in July, down significantly from 1.1% in June.^[ix] That 0.5% is much closer to the long-term average since data begin in 1940, 0.3%—and post-lockdown weirdness likely explains the remaining gap. A second special index, “All Items Less Food, Shelter and Energy,” slowed below 1% m/m for the first time since April, which happens to be the month that CPI inflation surged and set off everyone’s alarm bells.^[x] It rose just 0.3% m/m, matching its long-term average since data begin in 1967.^[xi]

That seems … normal? We aren’t dismissing the lingering pandemic weirdness in travel, food and energy. Of course, July is also just one month—trends take time to develop. But here is another way to see it: Services, which comprise 61.5% of the CPI basket, saw aggregate prices rise just 0.3% m/m, below the long-term average (0.4% since 1956).^[xii] That is even with the OER weirdness and lingering hotel price increases factored in. So while pandemic-related hiccups are still affecting supply and prices, that is confined to the universe of stuff, which also happens to be a minority share of GDP. Said differently, the majority of the US economy didn’t experience unusual inflation in July.

Inflation doesn’t have a preset market impact, so none of this is inherently good or bad for stocks. But we still see plenty of headlines alleging markets are somehow overlooking various risks, inflation chief among them—a statement that severely misunderstands how efficient markets work. They aren’t ignoring anything. They are just better at analyzing data than most pundits seem to be. In our view, they saw inflation trending toward normal months ago and acted accordingly.