While the market has focused on the collapse of Silicon Valley Bank and Signature Bank, today’s CPI report shows the Fed is making progress on inflation, but still has work to do.
CPI is improving, but perhaps slower than the Fed would like
CPI and Core CPI edged down to 6.0% and 5.5%, respectively, from a year-ago, the lowest they have been since the tail-end of 2021, albeit still representing a relatively slow rate of descent (Figure 1).
Core services continued to strengthen while core goods disinflation continued. Food price inflation has shown signs of easing, but remains elevated.
Figure 1: CPI is still falling, but at a slowing pace
Source: Bureau of Labor Statistics, Insight calculations, March 2023
The Fed’s closely-watched “supercore” inflation measure (core services excluding housing) continues to run strong at 6.1% year-on-year, despite a drag from medical services (partly due to a measurement quirk); transportation services wasbup 14.6%, with the airline sector in particular grappling with labor shortages.
Meanwhile, shelter inflation was once again the largest contributor and showed no signs of slowing down – up 8.1% year-on-year. We expect shelter inflation to slowly decelerate some time later this year given its ~12 to 18-month lag to private rental indices.
Figure 2: Most elements of CPI are slowing, outside of shelter, which is still increasing
Source: Bureau of Labor Statistics, Insight, March 2023
Signs of hope from small businesses
Meanwhile, consumer inflation expectations remain somewhat elevated both one and five years out with consumers expecting inflation to be ~6% one year from now, in line with current levels.
Figure 3: Consumer inflation expectations are still elevated
Source: University of Michigan, February 2023
At the same time, the latest NFIB small business survey showed the net percent of small business owners expecting to raise prices over the next three months has fallen four percentage points to 38%, the lowest level since April 2021 (Figure 4).
Figure 4: Small businesses are showing easing cost constraints
Source: NFIB small business survey, March 2023. https://www.nfib.com/surveys/small-business-economic-trends/
The Fed’s challenge will be complicated by recent volatility
The Fed will publish its highly anticipated refreshed “dot plot” and economic forecasts later this month. We still see a terminal Fed Funds rate between 5% and 5.5% (from the current mid-point of 4.625%) as a reasonable base case.
We do not believe the turmoil related to Silicon Valley Bank and Signature Bank is a systemic event, but it will have the potential to drive market uncertainty for some time. As such we believe a 25bp hike at the next Fed meeting is still a likely outcome.
In contrast to market pricing, we believe a “pivot” to rate cuts by year-end remains unlikely. Inflation is moving in the right direction but, with wage-sensitive “supercore” inflation still running strong and the ongoing tightness in the labor market, we expect the Fed to remain committed to its mission to tame the inflation problem.
Rather than using interest rates, we expect the Fed to address banking sector confidence through its liquidity operations, particularly the newly-introduced Bank Term Funding Program (BTFP). Additionally, if volatility were to deepen further, it might consider slowing or pausing its quantitative tightening operations to help cushion market volatility.