No turn of the inflation tide yet, but it is coming – Fed will press ahead

The consumer price index (CPI) rose more than expected in September, underscoring that price pressures are broad and longer-lasting than hoped. The September data provided no proof of clear and convincing evidence that inflation is moving lower, which the Fed is looking for to slow its aggressive rate hikes. However, the more forward-looking indicators that we track suggest that inflation will start moderating sustainably in the coming months and through 2023. We would need to see more progress on inflation for a sustainable rebound to materialize, but the equity market's rally on Thursday (10/13/22) after major indexes hit a new low for the year suggests that a lot of bad news is already priced in.  

September CPI comes in hotter than expected – While the headline CPI moderated slightly to 8.2% from 8.3%, it rose 0.4% from last month, above expectations for a 0.2% rise. The drop in gasoline prices provided some relief last month, but food prices rose again strongly. The core index, which excludes the volatile categories of food and energy, increased 6.6% from a year ago, the highest level since 1982¹. This increase was driven by the rise in prices for services on the back of a continued acceleration in shelter prices and a jump in medical care prices. More encouraging is that goods prices continued to moderate from a year-ago, helped by a decline in used car prices.

^{Source: FactSet}

This chart shows the difference between goods and service inflation where goods inflation has been falling while services inflation still moves higher.

Forward-looking data suggest that inflation will slow - The latest CPI report stresses how high inflation has broadened across the economy, pushing the Fed toward another outsized interest-rate hike. Yet it is worth noting that inflation is a lagging economic indicator, especially considering that housing, which makes up nearly a third of the CPI weighting, is a very slow-moving component. The exact timing is highly uncertain, but we expect goods inflation to slow meaningfully over the course of next year and services inflation to moderate more gradually for the following reasons:

• There is increasing evidence that supply chains have continued to improve. Transportation prices are falling, and capacity is increasing heading into the holiday season. Conditions at the ports appear to have normalized based on the backup of container ships. Shipping rates from Asia to the U.S. are 75% off their peak, and NY Fed's Global Supply Chain Pressure Index has fallen for five straight months to its lowest since Nov 2020¹. As a result, delivery times are improving.
• Prices paid by manufacturing firms for inputs have dropped to their lowest since June 2020, and prices paid by services firms have dropped to their lowest since Jan 2021¹. This easing should eventually find its way to consumer prices.
• Greater inventory and softening demand are starting to put downward pressure on used car prices. The Manheim index, a timely proxy for used car prices, has declined for four straight months and is down 13% from its peak¹.
• Wage growth continues to push services inflation higher, but it has started to moderate and will most likely continue to stay on that path as the labor market softens. While jobs growth is unusually strong, the number of job openings has started to decline as the economy slows.
• Housing activity is already cooling in response to the sharp rise in interest rates, as the average 30-year fixed mortgage rate topped 7% this week for the first time since 2000¹. Historically, shelter inflation has lagged the change in home prices by several quarters, so we expect housing to continue to apply upward pressure to prices in the near term.

Timely data suggest that the peak in inflation is behind us

^{Source: FactSet}

This chart highlights a few data points that shows falling inflationary pressures that haven’t filtered through to the CPI index yet.

The Fed will press on with rate hikes but likely pause in early 2023 – The key takeaway for the Fed is that inflation is not slowing fast enough for the bank to start signaling a change in its hawkish stance. The September CPI cements another outsized 0.75% hike in November and adds some uncertainty to whether the Fed slows to 0.5% in December. The silver lining is that because policymakers have already responded with the most aggressive tightening campaign in four decades, and because the market has already priced in another 1.25% of additional rate hikes this year, interest-rate expectations don’t have to recalibrate much higher¹. We think that a measured shift in underlying data could give the Fed some comfort to gradually slow its pace of tightening and pause over the next six months.

Patience is needed, but long-term opportunities are emerging – A sustained path of moderation in inflation remains the No. 1 condition, in our view, for markets to mount a sustainable rebound. Three or more readings will likely be needed to establish a trend, and the clock has not yet started, as the September data shows. However, forward-looking indicators suggest improvement on the inflation front as discussed above, and markets appear to have already discounted a lot of bad news. The rally in stocks following the worse-than-expected inflation data supports our view that the bear market is closer to its end than the beginning, and that broad investor pessimism could be a contrarian signal, helping set the stage for an eventual recovery as it unwinds.

With the Fed firmly on the brakes and economic growth slowing, the macroeconomic backdrop remains challenging, requiring patience from investors. Markets might stay range-bound for a while but should eventually start recovering as central banks become less hawkish. A focus on quality and defensive positioning is warranted in the short term. But with equity-market valuations declining nearly 30% and with a sizable amount of recession fear priced in, we are likely closer to a bottoming process today. This year's painful drawdown in both bonds and stocks has improved future long-term returns. We think investors can use the market downturn as an opportunity to rebalance portfolios and add quality investments at potentially more favorable prices.

Angelo Kourkafas, CFA
Investment Strategist

^{Source: 1. Bloomberg, Edward Jones}