Analyzing January’s CPI report: Is inflation stalling or still a concern for investors?

On February 1, Federal Reserve Chair Jerome Powell stated the “disinflationary process had started.” However, a series of strong economic data releases—most notably, the January employment and Consumer Price Index (CPI) reports—have some investors wondering if the “disinflationary process” could already be stalling. Here are our views on what the latest CPI report says and what it tells us about inflation going forward.

January CPI wasn’t that bad

While many investors were disappointed with the CPI report, the details were not that bad. Excluding food and energy, consumer prices rose 0.4% in January, about the same as December and up 0.1% from the November and October figures. However, it is undoubtedly true that a 0.4% monthly pace for inflation remains way too high. Inflation needs to slow to about 0.16% per month to achieve the Fed’s 2% target. So from that perspective, 0.4% is something of a disappointment. 

_{Source: Bureau of Labor Statistics} 

The Consumer Price Index (CPI) experienced a minor rebound, primarily due to increased goods prices - the cost of physical items. After declining for three consecutive months, goods prices rose by 0.1% this month, indicating that the downward trend had come to an end. This outcome was expected as it is not feasible for goods prices to keep falling indefinitely. We anticipate that as goods prices stabilize, services inflation will decline accordingly, and the combination of these two factors will lead us toward a more sustainable inflation path.

As we have detailed in prior articles on inflation, the largest component of services inflation is shelter. This is the figure the Bureau of Labor Statistics uses to estimate inflation in home prices and apartment rent rates. The most real-time estimates we have for both these markets indicate that prices are falling. For instance, the Case-Shiller Home Price Index has declined by 2.5% since June, while Rent.com reports that the median rent rate has declined by 4.4% since August. 

However, because the Labor Department uses all homes and all rental agreements (not just recent transactions), it tends to take a long time before lower prices today translate into lower shelter inflation in the CPI report. In January, shelter inflation rose at an 8.7% annualized pace. We think it is highly likely that this will decline in the coming months as today’s lower home and rent prices converge with the inflation estimate.

_{Source: Bureau of Labor Statistics} 

As you can see from the chart above, shelter is the dominant reason why Core CPI is still so high. We can take this a step further and estimate what Core CPI would be if shelter inflation normalizes. For example, say that shelter inflation averages 2% over the next year, and we hold all the other components at their January pace. In that scenario, Core CPI would be 2.06%. That would be well within the Fed’s comfort zone.

The “no landing” scenario

It's a pretty safe bet that shelter inflation will soon run at a much lower pace. The question that remains is whether other consumer prices could reaccelerate.

Many commentators use the term “landing” to describe various economic scenarios. A hard landing would be the economy falling into recession. A soft landing would be where inflation subsides, but unemployment doesn’t rise much. There’s also talk about a “no landing” scenario where the economy stays hot, and inflation remains too high.

Unfortunately, there is a risk such a thing could happen. If the jobs market heats back up in 2023, we could see wage growth jump again. If household incomes are rising, we can assume that consumer spending will also rise. If this were to occur, inflation could remain higher than the Fed will tolerate, resulting in more rate hikes than markets currently assume.

We don’t think this is the most likely scenario. There are reasons to be suspicious of the large employment gain figure from January, and without large job gains and/or wage growth, consumers won’t have enough income to keep boosting inflation. As the exercise above showed, shelter is the only thing keeping inflation above the Fed’s target. Hence, we believe that consumer spending doesn’t have to contract; it merely has to stay roughly steady for inflation to continue.

Facet’s portfolios are based on possibilities, not predictions

Our portfolio construction process is based on examining a number of possible market scenarios, putting little to no weight on which one we think is most likely. We believe this approach results in portfolio performance that can weather various outcomes, producing steadier results for our clients.

Heading into 2023, we believed it was possible that inflation would remain too high and that the Fed would wind up hiking by more than expected and/or keep interest rates high for longer than expected. We have overweighted companies with low debt burdens and high-profit margins to provide some protection against this scenario. Companies with lower debt levels won’t see their profits impacted as much by rising interest costs. Those with higher profit margins tend to sell products their customers really need, often because there are few competitors. Such companies have an easier time raising prices in the face of higher inflation.

It wasn’t long ago that the market’s biggest worry was a 2023 recession. Now everyone seems worried that the economy is too good. This is the nature of investment markets. There is always something to worry about. However, by being prepared for various outcomes, we can look past the worry and feel comfortable with our portfolio holdings. We believe this is the best way to meet your investing goals.