U.S. Inflation Turns Higher Again, Implications For The Fed

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
February 21, 2023

IN THIS ISSUE:

1. US Inflation Rises For The Second Month In A Row

2. What Is Driving Inflation Higher Than In Recent Years

3. Retail Sales Is Another Significant Driver of Inflation

4. American Consumers Are Still Spending Strongly

Overview – US Inflation Rises For The Second Month In A Row

The world is watching inflation trends much more closely than usual in the last few months. Not only did US inflation spike above 9% last year, a 40-year high, global inflation rose to 8.8% last year according to the International Monetary Fund, also the highest in years.

US inflation as measured by the Consumer Price Index (CPI) soared to an annual rate of 9.1% last year after remaining in the 2-3% range for the last decade, as you can see below. After peaking early last summer, the CPI trended lower the rest of the year, until December when it rose very slightly. Most forecasters didn’t pay much attention to the blip up in December.

Consumer Price Index

In January, however, the CPI increased a second month in a row, rising 0.5%, an annual rate of 6.4%. The Producer Price Index (wholesale prices) also rose significantly in January, up 0.7%, an annual rate of over 8%, the highest in decades.

These increases in inflation caught forecasters’ attention and made many wonder if the downward trend in inflation was reversing.

It's an important question because, as you know, the trend in inflation very much affects the Fed’s monetary policy and short-term interest rates. The Fed has made it very clear it is committed to getting inflation closer to its 2% long-term target and has already raised its short-term interest rate eight times in its effort to make that happen.

The latest back-to-back monthly rises in inflation raise serious concerns the Fed will have to raise interest rates even more than expected this year. Most Fed-watchers had forecasted the Fed would raise its short-term interest rate a couple more times this year, then pause around mid-year and would be able to begin lowering the rate again before the end of this year.

As I wrote on January 31, I did not agree with this forecast based on what I read from the Fed Open Market Committee (FOMC) which determines interest rate policy and what Fed Chairman Powell said in his speeches.

On February 1, the FOMC raised its Fed Funds rate by 0.25% to a target range of 4.50-4.75%, the eighth consecutive increase since March of last year. The next two FOMC policy meetings are on March 21-22 and May 2-3. I expect another Fed rate hike at both of those meetings.

If the FOMC raises the Fed Funds rate by 0.25% at each of those meetings, that will put the Fed Funds target range at 5.00-5.25%, the highest since the financial crisis of 2008-2009.

Federal Funds Rate

Fed Chairman Powell has indicated in recent speeches that the FOMC might deem it necessary to keep the Fed Funds rate at this level of 5% or above for an extended period, and this was before the January CPI increase of 0.5% (6.4% annual rate).

The next Consumer Price Index report will be out on March 14, and investors will be watching closely to see if inflation rises a third month in a row or turns lower once again.

The Fed’s favorite gauge of inflation is the Personal Consumption Expenditures Price Index (PCE), another widely-followed measure of price inflation. The PCE Index rose 5.0% for all of 2022 after rising above a 6% rate earlier in the year. The next PCE report for January will be released this Friday, February 24, and this will be watched very closely as well.

What Is Driving Inflation Higher Than In Recent Years

The rise in inflation actually began in late 2020 as you can see in the CPI chart above. The sharp rise in inflation in recent years was the result of many factors but chief among them was the significant increase in prices for shelter, food and energy.

Rising shelter costs accounted for about half the increase in inflation last year according to the Labor Department. The shelter component accounts for more than one-third of the inflation index and rose 0.7% in January and was up 7.9% from a year ago.

Put differently, the rise in housing prices is keeping a floor under inflation.

Energy also was a significant contributor, up 8.7% last year, while food costs rose 10.1%.

Rising prices meant a loss in real pay for workers. Average hourly earnings fell 0.2% in January and were down 1.8% from a year ago, according to a separate Labor Department report which adjusts wages for inflation.

While price increases had been abating in recent months, January’s data shows inflation is still a force in a US economy in danger of slipping into recession this year.

This has come despite Federal Reserve efforts to quell the inflation problem. As noted above, the central bank has hiked its benchmark interest rate eight times since March 2022 as inflation rose to its highest level in 41 years last summer.

“Inflation is easing but the path to lower inflation will not likely be smooth,” said Jeffrey Roach, chief economist at LPL Financial. “The Fed will not make decisions based on just one report but clearly the risks are rising that inflation will not cool fast enough for the Fed’s liking.”

Retail Sales Is Another Significant Driver of Inflation

Consumer spending makes up almost 70% of Gross Domestic Product, so the level of retail sales is another important component of inflation.

Last year Americans knocked out their holiday shopping early, leading to lower sales during the typically bountiful November and December months – and triggering speculation that the US consumer was tapped out.

That wasn’t the case. Last month, spending rebounded in a big way.

US retail sales surged in January by the most in almost two years, soaring 3% from December, the Commerce Department reported last week.

U.S. Retail Sales

Economists had anticipated sales would rise by 1.8%, after the 1.1% decline in December when consumers pulled back on spending amid high inflation and concern about the direction of the economy.

Instead, the figures easily topped forecasts, making January the largest monthly sales bump since March 2021 when a third round of stimulus checks were cut.

“The increase in retail sales, combined with the very strong January jobs report, reduce concerns that recession is imminent,” Gus Faucher, PNC’s chief economist, wrote last week. “Although some of the increase came from higher prices, more of it was from higher volumes.”

The increases crossed all retail categories, with some of the largest jumps at department stores (17.5%), food services and drinking places (7.2%) and auto dealers (6.4%), according to the report.

On a year-over-year basis, retail sales were up 6.4% from January 2022 when the Omicron variant was surging. Favorable weather, a strong labor market and post-holiday discounting helped contribute to the rebound in sales, economists said.

“Some of that strength was due to people coming back and buying things on discount, some of that strength was due to the fact we had an 8.7% increase in Social Security payments, which gave more cash to 66 million [people],” Diane Swonk, KPMG’s chief economist, told CNN this week.

January’s blowout report is likely to underscore the Federal Reserve’s resolve to keep raising interest rates to cool demand as it tries to rein in inflation, economists say.

“The economy remains strong, unemployment is low, and that is what is going to keep inflation elevated,” Chris Zaccarelli, chief investment officer for Independent Advisor Alliance, wrote in a note to clients last week.

He cautioned, “The Fed is going to need to raise rates higher – and hold them higher for longer – than people currently expect, and this is going to cause markets to go through some significant volatility, as stock and bond markets are priced for benign scenarios and not the more difficult one that we are headed towards.”

American Consumers Are Still Spending Strongly

The latest data highlights the continued resiliency of the American consumer, Matt Schulz, chief credit analyst at LendingTree, told CNN last week. “Americans overall have done a pretty good job of managing through some challenging times,” he said.

Consumers have been leaning more on credit cards for spending, he added, noting that while delinquencies are rising somewhat, “We haven’t seen them spike.”

In addition to drawing down extra savings during the pandemic, consumers have been helped by an easing in inflation and lower fuel prices in recent months, Mike Skordeles, head of US economics at Trust Advisory Services, said in an interview with CNN.

“In the back half of 2022, real incomes very much benefited from the sharp declines in gasoline prices,” he said. “That’s not a small thing to discount. It’s a couple hundred bucks on a monthly basis for the average person.”

Still, the spending spree is likely to wane as the Fed hikes continue to take their toll, Skordeles added.

The bottom line is the US economy is still in relatively good shape despite the increase in inflation. Likewise, retail sales remain strong. Sure, the economy looks to weaken somewhat later this year as the Fed continues to hike short-term interest rates.

But is a recession the most likely scenario? I don’t believe a recession is the most likely outcome. It could happen, of course, especially if inflation continues to rise, and the Fed has to raise interest rates more than expected. Time will tell.

Very best regards,

Gary D. Halbert

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