Key takeaways

  1. Inflation reverted to a normal 2.0% annual rate in the last two months, excluding food and energy, without any adverse economic trends
  2. July's Core CPI was driven solely by shelter inflation, with the cost of all other goods and services remaining unchanged
  3. Labor Department estimates of shelter inflation measure change in prices from several years ago until now due to lack of home turnover each year
  4. Despite expecting an economic slowdown in 2023, actual slowing has been mild and inflation appears to be normalizing
  5. With market shift to focus on potential for Fed rate cuts in 2024, Facet portfolios have had close results to benchmark so far in 2023
  6. Unless something gets in the way, the default long term direction of the market is expected to be positive making now a good time to invest

Has the battle against inflation been won? 

From 2010 to 2019, the Consumer Price Index (CPI) inflation measure grew at a 2.0% annual rate, excluding food and energy. In the last two months, that same measure grew at only a 1.9% rate. 

Obviously, a mere two months doesn’t prove anything, but this is clearly good news. Without having to suffer through a recession or a material increase in unemployment, inflation has reverted to a normal pace, at least in the short term.

But will this positive trend continue? Here are our thoughts.

The details are even better than the headline

For the month of July, Core CPI advanced 0.16%, almost exactly equal to the June figure. The details of the July CPI report add even more credence to the idea that inflation is rapidly normalizing.

If we look at the individual components, all of July’s inflation came from one source: shelter. I.e., the portion of household budgets dedicated to putting a roof over your head. 

The chart below shows the contribution to July’s Core CPI figure from home prices, apartment rents, and everything else. You can see that “everything else” amounts to virtually zero inflation.

chart showing the contribution to July’s Core CPI figure from home prices, apartment rents, and everything else.

Source: Bureau of Labor Statistics

The way the Labor Department estimates shelter inflation is a bit complicated. They attempt to measure the fact that, for most people, the cost of housing doesn’t change every month. 

For example, when you buy a house, your cost of shelter doesn’t change until you move. If one were to live in the same place for ten years, there would be zero inflation for those ten years attributable to that property. 

Then, if it were sold, there would effectively be ten years’ worth of home price appreciation accounted for all at once. This is basically how the CPI measures housing prices for inflation purposes.

As a result, the CPI is constantly measuring the change in prices from several years ago until now, not really what’s happening with home prices in real time. 

As the chart below shows, since only 2-4% of homes turnover each year, Shelter CPI tends to run at a somewhat slower pace than home prices during regular times.

Chart: home prices vs. Shelter CPI - 2014-2023.

Source: Bureau of Labor Statistics, S&P Case Shiller

So not only was shelter the only driver of inflation in July, but there is good reason to think shelter inflation will continue to subside a bit in the coming months.

Regardless, the inflation rate for all other goods and services was zero in July. We see that as an encouraging sign that perhaps underlying inflation pressure is easing more rapidly.

Immaculate disinflation?

The slowing of inflation so far in 2023 is impressive, especially given that unemployment has not increased. We argued that some kind of economic slowdown was highly likely coming into the year. The Fed was committed to quelling inflation and would continue to hike rates until the economy slowed enough to achieve that goal.

What actually happened?

The economy has slowed, but only mildly. By most measures, the economy has gone from a historically strong pace in the middle part of 2022 to a more normal growth rate presently. We can see this by looking at employment gains. 

We have shown the chart below a few times in past articles. It shows that during non-recessionary periods, total employment tends to grow at a 1-3% pace.

Line chart showing rolling six month payroll growth from 1984 to 2023.

Source: Bureau of Labor Statistics

As you can see from the chart, job gains were running well above historical norms in 2021 and 2022 but have more recently returned to the more typical 1-3% range. 

So far, it appears that economic activity returning to a more normal pace is enough for inflation to also normalize. This is what economists mean by a “soft landing.”

Coming into 2023, we believed a severe economic downturn was one possibility. Another was that inflation remained high. But we did see this soft landing as a third possibility. 

While we wanted to position Facet portfolios to defend against a weak economy and high inflation, we also wanted to ensure our members captured the substantial upside potential of a soft landing. 

We think the 2023 experience highlights the benefit of our approach. Had we made a single prediction about the macroeconomy: recession, inflation, or soft landing, we would have had a one-in-three chance of getting it right. 

Instead, we tried to build in some protection to Facet portfolios in case a recession occurred but maintained enough upside potential if it didn’t. 

As a result, Facet has produced results very close to the benchmark so far in 2023 despite building in defense for a recession that never came.

Will the Fed potentially cut rates?

If inflation remains low, the market will likely shift its focus to the potential for Fed rate cuts in 2024. Right now, futures markets suggest that 4-5 rate cuts (i.e., 1-1.25%) are expected in 2024.

While Fed Chair Jerome Powell has been downplaying the potential for rate cuts, eventually, rate cuts will make sense even if the economy does not fall into a recession. That’s because when the Fed considers setting its interest rate target, it thinks in terms of “real” rates. 

By that, we mean the stated interest rate less the rate of inflation. If the Fed wants to keep the real rate target steady, it must cut the stated rate as inflation declines. 

For example: 

  • If the Fed target rate is at 5.5% while the Core PCE inflation rate is at 4%, the real rate is 1.5%.
  • If inflation declines to 2.5% and the Fed still wants the real rate to be 1.5%, it will need to cut its target rate to 4.0% (2.5% inflation + 1.5% real rate).

The Fed itself is projecting cuts in 2024. As part of its quarterly Summary of Economic Projections, the median projects among Fed committee members was for 1% worth of cuts in 2024. 

Be aware of this when comparing different investment choices. 

Right now, very short-term T-Bills and Certificates of Deposit appear to have very high yields, but if the Fed winds up cutting rates in the coming months, those yields will fall rapidly. 

* Facet prefers to own a mix of maturities, even for members with short investment horizons.

Growth is the economy’s natural state

As we look ahead for markets, it is worth noting that growth is the natural state for both the economy and the markets, and contraction is the exception. 

In other words, unless something gets in the way, the economy tends to grow, and stock prices tend to rise. Overall, US economic growth has been positive in 37 of the last 40 years, and the S&P 500 has been up 33 of the same 40 years. 

It may be that inflation and rising interest rates are now fading as a potential downside catalyst. In our opinion, unless a new catalyst emerges, the market’s default long-term direction will likely be up. That makes now as good a time as any to start investing for your future.