While investor attention continues to pivot away from inflation and toward recession (see Monday’s video), inflation remains a very significant piece of the investing puzzle. The Fed is clearly still fixated on it, which means investors better continue to pay attention, as Fed policy remains one of the most important factors influencing asset prices.
When June’s 9.1% annual inflation increase was announced last week, the White House was quick to point out that the number was already outdated due to energy prices having fallen substantially already in July. That’s a fair point — AAA announced last week that the average price for gasoline in the U.S. had fallen from $5.00/gallon a month ago to $4.60. A decline approaching 10% in a key spending category is a big deal.
One of the underrated aspects of the inflation debate is that the CPI calculation isn’t a black box. The weightings of the various categories that comprise the index are well known. Here’s a recent chart that details what comprises the index.
Unfortunately, those broad categories don’t include "Energy" so we have to do a little more sleuthing. If we dig through the more detailed category weightings available from the Bureau of Labor Statistics, we find that the combination of home and motor transportation "energy" total up to roughly 7.5% of the CPI calculation. So (using round numbers for simplicity), a 10% decline in the energy weighting (of 7.5%) is definitely significant, as that would potentially lower next month’s CPI by 0.75%.
Housing would like a word
On the other side of the ledger sits housing, via the annoyingly labeled (and controversial) category "Owners’ Equivalent Rent" (or OER, for short). Checking the table above, we find that OER makes up a massive 30% of the CPI calculation — that’s four times the size of the energy weighting. So, to be clear, what happens with housing via OER is 4x as important to the future direction of CPI inflation as what happens with energy.
It’s this OER component that has kept me in the "inflation is going to stay sticky high for longer" camp. That’s not to say CPI might not be peaking and rolling over (maybe it is, maybe it isn’t). It’s simply to say that given the trend in rents, and the high weighting OER gets in the CPI calculation, it’s going to be difficult for CPI to decline quickly.
The graphic below from MI2 Partners shows why this is true.
There’s a lot going on there, but here’s the quick summary. The blue line shows the percentage change in single-family rents over the prior 12 months, which normally leads changes in the CPI — OER component data (red line) by 9-12 months. What MI2 Partners has done in this chart is show how the explosion in the blue line (rents) over the past year is likely to impact the OER component of the CPI calculation over the next several months.
Bottom-line, based on the increase in rents that has already happened, the OER component of CPI — which makes up 30% of the calculation — is going to face consistent and substantial upward pressure through (at least) the end of 2022.
Putting it all together
It’s hard to get overly precise with this, given that the rents/OER chart above doesn’t show us precisely where this measure sits today (it shows the trend increase from Feb 2022 to Jan 2023). But the point of this post isn’t to say precisely what CPI will be at any point in the future. Rather, it’s simply to point out that there is a structural, large component of the calculation that is going to act as a brake on the rate at which CPI declines in the months ahead.
That’s crucial as we evaluate what the Fed is likely to do. Investors are seeing the headlights of an oncoming recession and assuming the Fed will repeat what it did in similar circumstances in 2012, 2016, 2018, and 2020 — pivot sharply back to easing. That policy pivot is the "Fed put" that has kept a floor under stock market declines over the past dozen years. With the S&P 500 index currently down roughly -20%, the market is exactly at the level when the Fed has repeatedly changed policy and sent stocks ripping higher again.
But as we’ve pointed out repeatedly this year, inflation is a game-changer in this regard. Every one of those prior examples came with negligible inflation. That’s clearly not the case today with inflation ripping at levels not seen in over 40 years.
Our central thesis coming into 2022 was that inflation would force the Fed to tighten financial conditions despite a slowdown in economic growth. We’re at the point where the rubber hits the road and the Fed either continues tightening or they don’t. My view is that it’s going to be very difficult for the Fed to back away from its tightening policies while these headline CPI numbers keep coming in hot every month. Even if CPI were to fall over the next few months into the 8% range (or even 7%), that’s still going to be unacceptably high. That OER component makes it hard for me to see how the math works to get it much lower before the end of the year, even with a recession and falling energy/commodity prices.
That suggests the best the bulls can hope for in the short-term is the Fed pausing to "evaluate more data." The idea of a quick pivot back to easing seems very unlikely, barring some sort of blow-up in the credit markets. That could happen, but it’s also nearly impossible to predict.
All of this indicates that SMI members’ current defensive positioning remains appropriate, as market risks remain extremely high.