We have to bite the bullet – US inflation has stopped falling

The judgment on the inflation report is split down the middle. Some saw the data as “tame” (Reuters) or “benign” (Bloomberg). The FT says the top number opens the door to the rate cut next week, so also a dismissal. The WSJ writes “strengthening inflation poses challenge.” CNN said inflation “heated up.” The NYT wants to have it both ways: “Inflation sped up last month, but the details suggested cooling ahead.”

We think inflation data contains enough scary stuff to question the equity markets, which roared wildly on the release. The best you can say is that the drop in inflation has stalled. It’s not hard to find evidence of stickiness, with the 3-month average up to 3% annualized. WolfStreet writes this is “the sharpest increase since April and the fourth month-to-month acceleration in a row:”

Bright lights from surveys were wishful thinking, That includes the Conference Board and the University of Michigan as well as the small business survey. 

So is the rise really not meaningful? There’s enough in the report to arouse some fear.  In reality, the data showed a rise, however small, in the year/year to 2.7% in Nov from 2.6% in Oct. More tellingly, core services rose a dreadful 4.58% y/y. To be fair, the housing component of core services did abate, including not only rent but also “owners equivalent,” suggesting owners are regaining sanity. See the table from WolfStreet at the end. The single item with a minus sign is car and truck rental.

And core core rose to 2.4% in Nov from 2.3% in Oct. Core core (“supercore”) is ex food, shelter, energy and used vehicles—aka everything we spend money on.

In months past, the Fed has suggested it watches supercore as a critical factor. Critics say excluding the cost of shelter is unrealistic, at least in terms of how the public perceives inflation. The Fed’s excuse is that over 65% of Americans own their own homes and most have a fixed mortgage, so go away. But perception matters, and food and shelter are at the top of the list.  And shelter is still rising by 4.4-4.9%, if by less than before, and food rose 2.4% y/y in Nov.

We have to bite the bullet—inflation has stopped falling. To say it has stalled is okay, but to say it’s actually okay is not truthful. A surprising number of analysts are willing to overlook the inflation problem. One (MishTalk) writes “3.0 Percent is the New 2.0 Percent. The Fed and the markets are perfectly fine with inflation running above the Fed's long stated goals of 2.0 percent.”

The important Authers at Bloomberg concurs, albeit coming at it from another direction. He points out that “Jerome Powell’s favored measure of real rates — subtracting the one-year breakeven from fed funds — has dropped sharply. If the Fed wants to keep rates where they are, it has license to do so.”

The 1-year breakeven has risen back over 2% and “The most likely outcome is that the Fed has to accept inflation above 2%, and set rates higher than many in the market had hoped, to keep it from getting out of control at that level. There are many worse outcomes, but even this one isn’t currently priced in by the market. Tom Tzitzouris of Strategas Research Partners argues:

“’Today’s CPI tells us that the sticky level is not 2.0%, it’s more like 2.5%, or greater, and that means bonds could eventually have at least one more round of pain if breakevens correct to reflect this higher long-run level of inflation. This won’t stop the Fed from easing next week, but sticky inflation tells us that a pause is coming, and if breakevens surge too, expect the Fed to stop cold.’”

One deduction—we can continue to buy equities until the cows come home.

As of 4:40 pm yesterday, the odds of two cuts by March, including the one we expect next week, fell to 11.8% from 12.5% the week before, according to the CME FedWatch table.

There is a barely disguised fly in the ointment--commentators opining that Trump doesn’t really intend to do the things he spouts off about—they are just “negotiating positions” and even if he does try to pull some of the stunts, the Congress and judicial system will hold him in check. How did that work last time? To say Trump engages in sophisticated gaming strategies is preposterous. Maybe we are just tired already of feeling afraid.

If history repeats, second thoughts will start appearing. It remains to be seen how those second thoughts proceed. Everybody and his brother expects the Fed to cut next week from 4.5% to 4.25%. The CME FedWatch shows 99.9%! Going forward, though, only 59.5% expected another cut by the March 9 meeting yesterday morning and that had fallen a bit to 55% by 10 pm. We shall see how much more that number fades.

Central Bank meetings

RBA December 9-10.

BoC December 11.

ECB December 12.

SNB December 12.

Fed December 18.

BoE December 19.

Bank of Japan Dec 19.

Forecast

The stage is set for the Fed to cut next week, stalled progress on inflation notwithstanding. The markets got what they wanted to see and behaved accordingly. When will be see talk again of Trump policies likely to raise inflationary pressure? Expectations of additional cuts are being pushed out and perhaps disappearing for Q1. This favors the dollar, especially in light of superior relative US growth.

All the same, we are not out of the woods in the euro and can easily see a bounce after the ECB decision.

Note to Readers: We will have full reports tomorrow but no reports next Monday through Wednesday, returning on Thursday. Having eye surgery. 

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