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    Instant Insights: We are beginning our descent

    Instant Insights: We are beginning our descent

    November 11, 2022 Fixed income

    After a string of disappointing CPI prints, consumer prices for October rose 7.7% year-on-year, below 8% for the first time since February 2022 and lower than 7.9% expected. Core inflation also rose less than expected at 6.3%, down from last month’s 40-year high of 6.6%.

    The Fed will likely see it as further justifying their guidance to downshift their rate hikes. Nonetheless, the path to 2% CPI remains a way off.

    Goods prices fall into deflation and services inflation slows

    Core goods prices moved into deflation on a month-on-month basis at -0.4%. Used cars were the largest negative contributor although areas like apparel also fell (Table 1).

    Core services slowed for the first time in four months, from 0.8% to 0.4%, and was unchanged year-on-year at 6.7% (still a 40-year high). This was partly the result of an annual change in the calculation of prices for health services, which fell sharply.

    Table 1: Flexible CPI components move into deflation while sticky sectors slow slightly1

      Sticky Flexible Non-Core
      Health services Owners' Equivalent Rent Airfare Used Cars Apparel Food Energy
    12 month Average 0.4% 0.5% 2.9% 0.4% 0.4% 0.9% 1.6%
    May-22 0.4% 0.6% 12.6% 1.8% 0.7% 1.2% 3.9%
    Jun-22 0.7% 0.7% -1.83% 1.6% 0.8% 1.0% 7.5%
    Jul-22 0.4% 0.6% -7.8% -0.4% -0.1% 1.1% -4.6%
    Aug-22 0.8% 0.7% -4.6%  -0.1%   0.2% 0.8% -5.0%
    Sep-22 1.0% 0.8% -0.8% -1.1% -0.3% 0.8% -2.1%
    Oct-22 -0.6% 0.6% -1.1% -2.4% -0.7% 0.6% 1.8%


    Core goods move into deflation, as used cars become the largest drag

    Used cars, which inflated over 35% in 2021, continued to normalize. The component was the largest detractor this month, taking 0.1% off the month-on-month CPI figure.

    The normalization may not be over, as the Manheim Used Vehicle Index, a leading indicator, fell the most since 2008 on a year-on-year basis (Figure 1).

    Figure 1: The Manheim Used Vehicle Index fell the most since 20082


    Medical services adjustment provides some services relief

    A contributing factor to the slowdown in "sticky" services inflation was an annual reset within the health insurance CPI measure. This has occurred every year since 2018, when the Bureau of Labor Statistics introduced annual adjustments to the measure that sets its pace for the following year.

    Last year, health insurance CPI was a relatively persistent ~+2% month-on-month. However, the latest adjustment took it down to ~-4% month-on-month (Figure 2), setting a deflationary tone within this measure for the year ahead.

    Figure 2: The latest annual reset in healthcare CPI pushes the measure into likely persistent deflation3


    The BLS estimates health insurance CPI, in large part, by calculating the growth in the ratio of insurer retained earnings to total premiums. However, the BLS only receives the data annually, primarily from the National Association of Insurance Commissioners (NAIC) and the California Department of Managed Health Care (DMHC) and spreads the impact over the course of the year.

    This took ~6bp off CPI month-on-month. Due to base effects, assuming a consistent 2.5% monthly drag over the next year (in line with the latest NAIC figures) health insurance CPI could fall below -20% year-on-year (Figure 3), into 2023, taking over ~40bp off year-on-year CPI by this time next year.

    Figure 3: Health insurance CPI will fall deeper into deflation on a year-on-year basis4


    Rental CPI leads the charge for “sticky” services CPI

    As we have long highlighted, shelter inflation is the one to watch for clues on the path of Core CPI. We expect it to remain high into 2023, but signs are building that it may slow into Q2.

    Shelter inflation was the largest contributor to the index at 0.3% month-on-month. This is a notoriously “sticky” indicator. It is largely based on surveys that are refreshed every six months, reflecting the length of rental contracts.

    Other measures, such as the Zillow rental index, offer more up-to-date insights on rental pricing trends, albeit they do not reflect actual prices paid as well as the CPI index does because of the focus on new tenants rather than all tenants. The BLS estimates that shelter inflation lags measures like Zillow’s by ~12 months. The latest data therefore indicates shelter inflation may begin to fall by the end of Q1 2023 or the start of Q2 2023 (Figure 4).

    Figure 4: Leading indicators for shelter inflation indicate it will fall, but the path will likely be a lot slower than private rental indices5


    However, given the fact that shelter CPI is largely sampled with inherent lags, we believe its path down (as with its path up) is likely to be far more gentle than the Zillow index.

    Energy prices rebound, but remain under control for now

    Energy and gasoline CPI rebounded this month, snapping three straight months of declines in which it was the index laggard.

    However, much of this appears related to a 7% rise in global oil prices at the start of October, which has since moderated. Daily gasoline prices similarly rose ~3% at the start of October but have also since reversed the move.

    Further, oil prices are also currently 31% below their peak (following Russia’s invasion of Ukraine), with favorable base effects likely to follow in Q2 2023. Gasoline prices are 24% below the peak.

    It is also worth noting the potential for positive surprises relating to any de-escalation or even resolution of the Russia / Ukraine war for food and energy inflation.

    We believe that absent further energy price spikes, we have seen peak CPI.

    Base effects are helping to push CPI down

    This time last year, CPI sharply accelerated from summer levels of ~5.3% to ~7% by year-end. These “base effects” are now kicking in, meaning there will be a higher hurdle for year-on-year inflation to keep accelerating.

    To illustrate, if monthly inflation were to stick at 0.5% (the current 6-month average), base effects would send year-on-year CPI down to the 5% to 6% range by June 2023 (Figure 5).

    Figure 5: Base effects could help CPI move to at least the 5% to 6% range into Q1 and Q2 20236


    Absent a renewed inflationary impulse, it increasingly looks to us like we have passed peak inflation. Nonetheless, the Fed’s 2% target is still a long way off.

    We are beginning our descent

    The Fed will be encouraged to see inflation move in the right direction, and base effects bode well for 2023. However, the Fed is still focused on its 2% inflation target.

    As such, the central bank will continue to hike, but we expect them to “downshift” to smaller hikes. For now, a 50bp hike remains a solid base case for December in our view. The pattern of data will determine how many hikes are left. There will be one more payrolls survey and another CPI print in between, which the Fed and markets will watch closely.

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