- Overall inflation was 7.7% over the last year, down from 8.2% last month and 9.1% at its peak in June.
- Excluding food and energy, prices rose 0.3% in October, down considerably from 0.6% growth the previous month.
- High-interest rates have substantially cooled off the housing market.
- The pace of hiring, while still strong, has slowed down significantly.
- Consumer spending has also slowed in recent months. These are all classic signs that inflation should be subsiding.
The October Consumer Price Index (CPI) report gives us some very real hope. The report, released on November 10, touched off a 5.5% rally in the S&P 500. That was the largest single-day gain in over two years.
Here is why we view this report as an optimistic sign and what it might mean going forward.
What Was in the CPI Report?
The headline figures from the CPI report were encouraging. Overall inflation was 7.7% over the last year, down from 8.2% last month and 9.1% at its peak in June. Excluding food and energy, prices rose 0.3% in October, down considerably from 0.6% growth the previous month.
The report gets even more encouraging when you dig into the details. The price of physical goods, i.e., any non-food item you might buy in a store or online, declined by 0.4% this month.
We have been anticipating this, as many retailers have been talking about rising inventories in recent months. It's a classic sign of prices being too high, suggesting that, before too long, we'd see discounted prices.
Higher services prices somewhat offset the outright decline in goods prices. However, the Shelter component dominated services inflation.
The way the Bureau of Labor Statistics estimates Shelter inflation is complicated since it partially involves guessing the extent to which home price increases impact consumer budgets. While their methodology does a pretty good job of estimating this, it is well-known by economists to operate at a lag to the real housing market. By this, we mean the rapid increase is still influencing the Shelter component of the CPI in home prices that occurred in 2021 and early 2022.
The fact that home prices have slowed way down (and maybe even started declining) has yet to have much influence over the CPI, but it eventually will. In other words, the current Shelter estimate is probably overstating the effect of home prices on current inflation.
Putting all this together, we are seeing goods prices decline, and while services prices are still rising, they too are poised to slow down in the near term. So, all-in-all, this was a very positive inflation report.
Is Inflation Finally Subsiding?
Our view has been that the inflation surge we've experienced over the last year has been primarily driven by excess demand. That is to say, consumer spending is outstripping the economy's ability to produce. If that is the case, then some slowing of spending is necessary to tame inflation.
This is precisely what the Federal Reserve is trying to achieve. Fed Chair Jerome Powell has said a few times that a period of "below trend" economic growth is probably necessary to bring inflation down. So by raising interest rates, the Fed is trying to make borrowing money to spend today more expensive, which is their best tool for bringing about a somewhat slower pace of overall spending.
It has also been our view that once spending cooled enough to bring better balance to supply and demand, the pace of inflation would move steadily lower. Inflation is like a pot that is boiling over. Once you turn the heat down enough, the water stops boiling—problem solved.
It is too early to know for sure if this process has begun. After all, this is only one inflation report. However, combining this inflation report with the other evidence we have, we are optimistic.
High-interest rates have substantially cooled off the housing market. The pace of hiring, while still strong, has slowed down significantly. Consumer spending has also slowed in recent months. These are all classic signs that inflation should be subsiding. This CPI report adds to the evidence that it is actually declining.
What Does This Mean for the Fed?
At the Fed's November meeting, Chair Powell said that the Fed would likely be slowing the pace of their rate hikes starting at their December meeting. The Fed has now hiked rates by 0.75% four meetings in a row, but with signs the economy is slowing, they no longer see the need to be quite as aggressive.
This inflation report only reinforces the idea that it is time for the Fed to slow down. As we said earlier, as soon as supply and demand reach a balance, inflation will likely continue subsiding on its own. The Fed doesn't need to continuously hike rates to make that happen.
This is also good news in terms of recession risk. If prices are decelerating now, the Fed doesn't have to keep trying to slow the economy. In other words, the sooner inflation slows, the greater our chance of avoiding a recession, or at the very least, avoiding an especially deep recession.
What Does This Mean for Your Portfolio?
There are a lot of "ifs" in the prior section, but at the very least, this more benign inflation report opened up the possibility of some happy outcomes for the economy. This is why stocks surged so much the day the report was released. Markets have been searching for the moment when inflation would start to subside, bringing about an eventual end to Fed rate hikes. We may have taken one step in this direction with this CPI report.
It also illustrates an important point about bear markets. They usually end not because our problems get solved but because things stop getting worse. Most bear markets end with a sudden and violent rally.
Again, we don't know if this bear market is actually over, but stocks climbing over 5% in a single day is an example of both of these points. The rally was a reaction to the possibility that inflation has stopped getting worse.
These massive up days in stocks have historically been clustered around the end of bear markets. We may see more of this kind of volatility going forward.
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