Zacks Investment Management

Marcia G. from Tacoma, WA asks: Hi Mitch, I saw that the latest inflation numbers were a great improvement, and the stock market keeps going up. I’m writing to ask if you think this will continue. I know the market will go up and down over time, so my question is focused on inflation. Does it keep getting better from here? Thank you.

Mitch’s Response:

Thanks for writing – you’re right to point out improving inflation data. Year-over-year changes in the consumer price index peaked at 9.1% last June, falling to 4% in May and now 3% in June. That’s a solid downtrend, in my view, and I see a possibility that pressures could ease further in the second half of the year.¹

But it may not happen immediately. One factor to consider is that June 2023’s inflation print is a year-over-year comparison to the inflation peak in June 2022, so the comparisons will become harder from here. I also think it’s important to focus on Core CPI, not the headline figure when wrapping your head around where the U.S. and the Fed are in the inflation battle.²

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Doing so paints a slightly less rosy picture. Core CPI, which strips out volatile food and energy categories, rose by 4.8% year-over-year in June, which also registered as a solid improvement from May’s 5.3% print but reveals a much greater distance to the Fed’s 2% target. Core CPI matters more to the Fed since they view food and energy contributions as highly volatile and also because they view the core measure as a better predictor of future inflation. As seen in the chart below, for instance, Energy was an outsized driver of the 3% headline figure, which could change considerably from month to month.

Source: U.S. Labor Department⁴

Because of the June 2022 to June 2023 comparison, I would not be surprised if the July inflation reading is slightly higher than June’s. I wouldn’t take that as a signal that inflation is back on the move. Underlying inflation pressures have been falling, and I think will continue to do so. If I had to cite three factors that will drive inflation lower in the coming months and quarters, I would look at producer prices, M2 and M4 money supply, and owner’s equivalent rents. All of these measures should contribute to further downward pressure from here. 

Specifically, the ‘shelter component’ of CPI is about one-third of the index reading. One feature is a quirky component called owner’s equivalent rent (OER). This component is what homeowners would hypothetically pay to rent their own houses, and it continues to place upward pressure on the headline figure as seen in the chart below:

The Shelter Component of CPI (purple line) Lags the Headline CPI figure (red line)

Source: U.S. Labor Department⁵

Data on home prices and rents suggest this pressure is going to fade significantly in the coming months, which should only pull the Core figure even lower. As far as reaching the Fed’s 2% target, I’m not sure that’s in the cards for 2023. But I also do not think we need a recession to get there. I would argue that inflation can gradually scale lower with below-trend growth, which is what the U.S. economy has been producing in 2023. An economic “soft-landing” is looking increasingly likely.

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Disclosure