2023-07-12 17:05:49 ET
Summary
- The Labor Department reported Wednesday that the inflation rate dropped to 3%, its lowest reading in more than two years.
- Travelers received the greatest reprieve in June, with significantly lower airfares and car/truck rental rates.
- Prices remained sticky in other categories, namely in vehicle ownership through higher insurance and repairs/maintenance.
- Addressing rising insurance premiums may prove challenging through rate policy. The challenge is compounded by the dynamics surrounding shelter costs.
- With these considerations in mind, I believe the Fed is on path to a policy mistake.
The Labor Department reported Wednesday that the consumer price index (“CPI”) rose at its slowest pace in more than two years. Though positive, the report isn’t expected to change the outcome at the Federal Reserve’s July 25-26 meeting.
June CPI Headline Inflation Rate
The index rose 3% in June, down from 4% in May and well below the recent peak of 9.1% in June 2022. Observers would have to navigate back to March 2021 to see a comparable inflation reading.
For the month, CPI rose 0.2%, also below expectations . And core CPI, which excludes volatile food and energy prices, was 4.8% in June, down from the 5.3% reported in May.
Like the topline rate, core CPI has been on a continuing downtrend since its peak in September 2022. The monthly rise in core CPI was also the smallest since August 2021.
Market Reaction To June CPI Report
Stocks rose through mid-afternoon trading following the report. Both the Dow ( DJIA ) and the Nasdaq ( NDX ) climbed over 100 points. The S&P 500 Index ( SP500 ) was more muted. Bond yields moved lower, with the 10-YR note falling to 3.867%.
Inflation Drivers In June
Energy prices increased in the month of June as travelers embarked on their summer trips. But prices are still down significantly YOY. The energy commodities index, which includes gasoline and fuel oil, is down about 27%. This primarily accounts for the overall decrease in the headline rate.
BLS - June CPI Report
Transportation services, on the other hand, are up 8.2%. This is due to vehicle insurance and maintenance/repairs, which are up more than four times the overall CPI, at 16.9% and 12.7%, respectively. To the likely dismay of vehicle owners, the rate of growth in this category has shown no signs of slowing. In June, the two lines items were up another 1.7% and 1.3%, respectively.
An increase in accidents and the associated costs, such as medical bills and litigation, are driving the bumps in these categories. Losses suffered in natural disasters, such as Hurricane Ian, also are providing insurers, such as Allstate ( ALL ), more cause to recover their losses. And looking ahead, premiums are expected to continue rising through the end of 2024, with another 5% to 10% increase possible, according to industry group Insurance Information Institute.
In one break to travelers, airlines and car/truck rentals are each down 18.9% and 12.4% YOY. Flyers particularly benefited in June as fares dropped 8.1%. Consumers can thank lower fuel prices for the savings. Investors should expect Delta Air Lines ( DAL ) CEO, Ed Bastian, to elaborate further on the pricing and demand environment when the company reports results on Thursday.
Related, but stated separately, drivers and travelers also could cheer lower prices for used cars and trucks. Following two consecutive months with monthly increases of 4.4%, prices pulled back by 0.5% in the month of June. Based on the Manheim Used Vehicle Index, which reported its largest monthly drop in June, the outlook appears promising for further declines in the months ahead. Though new vehicles are still up 4.1%, the trend remains positive. New prices were flat in June following declines in April and May.
In the grocery aisle, the food at home index was flat in June following a 0.1% increase in May. Though the index is still up 4.7% YOY, shoppers have benefited from declines in key categories. The price of eggs, for example, is down 7.9% from last year.
In the fruits and vegetables category, prices are up 1.1%. Depending on what one eats, this could either be seen in a positive or negative light. While potato prices are up 6.5%, with a 0.7% monthly increase, citrus fruits are down 5.5%, having declined 2.3% in June. Apples, too, appear to be pulling back. Prices here were also down 2.3% in June.
Will The Fed Increase Interest Rates?
The decline in the CPI to 3% is promising. It also suggests that the Commerce Department’s index for personal-consumption expenditures (“PCE”), which will be released later this month, also will report a decline. The expected decline in the PCE is important since it's the Fed’s preferred reading.
Inflation, nevertheless, remains above the Fed’s 2% target. This makes it likely that the Fed will increase rates by another quarter percentage point when they meet in two weeks. This shouldn’t shock markets as minutes from the Fed’s June policy meeting indicated that officials were intending on two more increases this year.
In one sense, continuation makes sense. Prices in certain categories are proving sticky. The growth in services-based spending, such as eating out, continues to increase. The relevant food away from home category added another 0.4% in June and is up 7.7% YOY.
More concerning is the growth in prices for insurance and maintenance/repairs. Granted, the overall transportation services index grew at a slower pace from the prior month, but this was primarily due to the decline in the rental and airfare market.
The isolated pressure from insurance and maintenance/repairs, which impacts most Americans, may prove trickier to address via the rate cycle. Losses from major weather events have factored in more materially in recent periods. Recent flooding in the northeastern U.S. may further compound this market. And further rate increases by the Fed may only prove counterintuitive in the insurance market, since insurers are allowed to recapture their costs via increased premiums.
Shelter also creates a complication for the Fed. In contrast with the probable continued stickiness in other categories, the shelter component may deflate more quickly than expected. In June, shelter costs accounted for 70% of the monthly increase in headline CPI.
By one measure, this category, too has proved resistant. June rents, for example, were still up 8.3% YOY, with owners’ equivalent rent up 7.8%, consistent with prior months. Zillow’s ( Z ) recently released monthly rental report , however, showed that rental rate growth has normalized to pre-pandemic levels.
More notably, Senior Economist Jeff Tucker noted in his report that a record-high number of multifamily units were under construction in May. These units will soon hit the market just as rental growth has stalled. The added supply, then, should begin to place downward pressure on rents. By Tucker’s estimates, CPI rent growth is expected to fall to 6.4% by December.
The expected decline in the rental component will have an outsized impact on overall CPI due to its current weighting. But this will be on a lagged basis since the CPI metric includes both new and existing leases. The inclusion of existing leases inherently creates a lag since tenants’ rents typically change just once a year.
By moving forward with continued increases, the Fed risks overshooting key components whose deceleration is expected to increase in the back half of the year. At the same time, their increases are unlikely to change the trajectory on stickier line items, such as insurance premiums.
With these considerations in mind, I believe the Fed is on track for a policy mistake and will likely be compelled into pivoting to a rate cutting cycle beginning in the first quarter of 2024.
For further details see:
June CPI Report: What It Means For Consumers And Markets