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Investment Strategy

February 21, 2023

Investment Strategy Brief: Disinflation Disrupted

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Below is a transcript of this week’s video:

January’s inflation data came in above consensus estimates. The headline and core inflation numbers on a year-over-year basis registered 6.4% and 5.6% gains, respectively. Now both may have peaked, but both remain above the Federal Reserve’s target of 2%-2.5%.

Beneath the surface, we can look at various components of CPI. We can note that goods price inflation has moderated, but inflation in services and shelter remains sticky. Shelter is known to be a lagging indicator within CPI, and it remains hot. Fed Chair Powell has pointed to “services excluding shelter” as a key subcomponent that will be monitored to gauge embedded inflation trends in the U.S. economy.

We note the month-over-month change in core CPI, which removes the impact from the more volatile food and energy components. Ideally, the Fed would prefer to see monthly inflation fall to (or preferably below) the 0.3% range in the short to medium term, which if annualized would be roughly consistent with their longer-term target range. Looking at the last three-month average of month-over-month changes in the subcomponents of goods, services ex shelter and shelter, we see that overall, goods price inflation has actually declined, but other components that are sticker remain above the Fed’s comfort zone.

We have seen a couple months of 0.3% month-over-month inflation. This month, the increase was remarkably broad-based, highlighting the pitfalls of straight-line extrapolating a few months’ worth of encouraging inflation reports. Now if more moderate inflation continues, year-over-year inflation will mathematically subside to below 4% by the second half of 2023. After seeing inflation around the 9% mark in mid-2022, the Fed will likely feel their efforts have been reasonably successful. This could be a silver lining that eventually take pressure off the Fed and allow them to, at a minimum, stop hiking rates. Having said that, achieving their 2.0% target may require their persistence in holding rates at these higher levels.

But given all of this, where does that leave the state of monetary policy at this point? Well to start, the fed funds rate remains meaningfully above the neutral level, suggesting that the state of policy is tight and getting tighter. The fed funds futures market just two weeks ago suggested that investors did not see the Fed reaching the 5% threshold, and expected the Fed to cut rates in the back half of 2023. Now the most recent inflation report, combined with a stronger-than-anticipated January employment numbers, has strengthened recent assertions from the Fed for sustained tightening over the coming year. So, the fed funds futures markets is now pricing in a path of additional rate hikes this year, with the curve peaking at 5.3% in May and no longer see a rate cut as a sure bet in 2023.

To summarize, inflation continues to moderate, but last week’s inflation report put a dent in the speedier disinflation hopes as more volatile components of CPI, such as goods, do appear to be declining, but stickier components, such as shelter and services ex-shelter, are not. Powell has specifically cited that the services ex-shelter indicator of CPI is what he’s watching to gauge embedded inflation trends in the U.S. economy. Stubborn inflation has shifted market expectations back toward the Fed remaining tighter for longer.

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