As Inflation Withers, the Fed Remains Behind the Curve

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The equity markets were slightly positive for the week, through Thursday. Then hostilities broke out in the Middle East. The price of oil shot up by $5/bbl. and equities tanked on Friday, with the DJIA off -1.79% (-770 points), the S&P 500 lost -1.13% (-68 points), the tech heavy Nasdaq fell -1.30% (-256 points),  and the small cap Russell 2000 lost -1.85% (-40 points).

It was a mixed week for the Magnificent 7. TSLA was up more than 10%, but still remains well below its mid-December high. For the week, NVDA, MSFT, and GOOG were also up, but only marginally (MSFT hit an all-time high on Thursday) while AAPL, META and AMZN were down slightly.¹

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Inflation Quelled?

On Wednesday (June 11^th), May’s Consumer Price Index (CPI) came in below market expectations. Both the headline and the core showed up as +0.1% for May while market expectations were for +0.2% for the headline number and +0.3% for the core (ex. food and energy). Looking at just the past three months and annualizing, the headline is rising at a 1.0% rate and the core at a 1.7% clip, both below the Fed’s 2.0% goal.^{2 3}

Looking at the detailed data for May, there appears to be a great deal of deflation now entering the marketplace. Some examples (per Rosenberg Research):

• Airline fares:   -2.7% (down four months in a row)
• Energy:   -1.0% (negative in two of the past three months)
• Furniture:   -0.8% (biggest decline this year)
• Used Vehicles:  -0.5% (negative three months in a row)
• New Vehicles:   -0.3% (biggest decline this year)
• Apparel: -0.4% (negative -0.2% in April)
• Hotels/Motels: -0.1% (negative three months in a row)

Unfortunately, the Fed and the media look primarily at the 12-month result (2.4% for the headline CPI and 2.8% for the core reading).^{2 3} Our analysis shows that, if the current three-month trend continues to year’s end, the 12-month CPI may fall below the Fed’s 2% target in December.  

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What the Year/Year CPI Would Hypothetically be at the Current 3-Month Inflation Rate^{2 3}

Note that at the 1.7% annual inflation rate assumed in the table, inflation remains persistent through Q3, likely a reason the Fed is in no hurry to lower rates.¹

Then, on Thursday, the Producer Price Index (PPI), an index of prices paid by businesses, showed up equally as tame as Consumer Prices. May’s headline index rose +0.1% from April’s levels (in April this index showed up as -0.2%). On a year/year basis, the headline May PPI rose to 2.6% from April’s 2.5% (but still on a negative trend) while the year/year core (ex-food and energy) fell to 3.0% from April’s 3.2%.⁴

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The quelling of the inflation dragon can further be seen in the attitude of small businesses toward this scourge. Note in the graph the downtrend in the NFIB’s question to small businesses as to the importance of inflation as a problem for their business (now below 15%).¹

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The Labor Market

Also noteworthy in Thursday’s data releases was the rise in Initial Jobless Claims (those filing unemployment claims for the first time) to 248K the week of June 7^th. This was above the consensus estimate of 242K. Worse, Continuing Unemployment Claims (those previously filing for unemployment benefits and continuing to do so) rose to 1.956 million (week of May 31^st) from 1.902 million the prior week. That’s an increase of more than 50K! And it’s the highest level of such claims since mid-November 2021. (Note: In November ’21 the Fed Funds Rate was near 0%).⁵ Look at the rise on the right-hand side of both of the charts shown below.

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Rosenberg Research, in its June 13^th missive (Breakfast With Dave), calculated that same store retail sales rose +1.6% in Q1, below Q4’s +2.2% growth. However, after accounting for inflation, sales volumes actually fell -0.2%. Conclusion: the rise in nominal sales was all due to rising prices. In another ominous sign, inventory levels have risen +1.7%. (Note that some of the inventory rise may have been due to pre-tariff stockpiling, but, for sure, some of it was due to falling real sales.) As a result, it does appear, from the aggregate data and from comments from the major retailers at their Q2 shareholders’ meetings, that consumers are tightening their purse strings.¹ What makes this economy different from the post-COVID experience is that there are no “excess savings” to be used for future consumption. In addition, given the bond market’s (and some politicians’) angst over the growth of the Federal Debt and future built-in deficits, there isn’t likely to be another round of  “stimulus checks,” like there was in the COVID period, if the economy exhibits negative growth.¹

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A Critical Time for the Fed

Because the Fed’s policy actions affect the economy with a lag, i.e., current actions have an impact several months later, it is our view that the Fed should be lowering rates now, as its 2% inflation target appears assured, there appears to be some deterioration in the jobs market, and consumption appears to be slowing.¹

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Unfortunately, Chairman Powell, not wanting to appear to be beholden to President Trump (a Fed independence issue), is now likely to wait until the soft (survey) data show up in the hard data. (In the Fed’s most recent Beige Book, published every two months, comments from businesses in all the Federal Reserve Districts were downbeat, i.e., the economy appears to be softening.) Nevertheless, because of politics, the market’s odds of a rate cut, by meeting, as shown in the next hypothetical table, are low for the June and July meetings, not becoming significant until September (when the economic slowdown becomes more noticeable).¹

As noted, since the 2% inflation target appears to be highly probable by year’s end, it is our view that, because of the lag in the impact of Fed policy changes on the economy, the Fed should be lowering their benchmark Federal Funds Rate asap. Other major central banks, like the European Central Bank, the Bank of England, and the Bank of Canada, have already lowered their benchmark rates, some several times.¹

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Final Thoughts

It was a double whammy on Friday as both equity and fixed-income prices fell due to escalated hostilities in the Middle East. The three major indexes were down slightly for the week with only the small cap Russell 2000 showing a small uptick. It was a mixed week for the Magnificent 7.¹

The week’s inflation releases were significant with both CPI and PPI showing a significant moderation in inflation.^{2 3 4}

The labor market has begun to show cracks. Both Initial and Continuing Jobless Claims remain on a rising trend, and that likely signals a rise in the unemployment rate in the next data release. The JOLTS confirms this trend.⁵

It is a crucial time for the Fed. At this week’s upcoming meeting (June 17-18), the market has set the odds on a rate cut at 0%, and only 18.6% for a cut at the Fed’s July conclave. It isn’t until the September Fed meeting that the consensus calls for a rate cut. Our view: If this is the case, the Fed will, once again, be behind the curve as the economy is slowing and the inflation genie has been put back in the bottle.¹