Investment Strategy Brief:
Inflation Insights

Below is a transcript of this week’s video.

Hi, this is Ilona Vovk with Investment Strategy at Glenmede. 

Last week, June’s Consumer Price Index (CPI) report illustrated that encouraging progress toward the Fed’s 2% inflation target continues to be made. The report showed consumer inflation coming in a touch below consensus estimates. The headline and core inflation numbers on a year-over-year basis, shown by the blue and yellow lines here, registered 3.0% and 4.8% gains, respectively. The core measure, which excludes food and energy, is being more closely followed as a measure of key underlying inflation trends. With a 4.8% annual growth pace, it’s the lowest since March 2021.

Now another way to look at how inflation is processing is by taking a look over the last 3 months. Shown here by the blue bars is Core CPI, a 3-month annualized percent change. The most recent data point suggests that, although progress is being made, core CPI is moderating slower. Ideally, the Fed would prefer to see annualized inflation fall to (or preferably below) the 3% range, as shown by the grey area.

If we look on the right side, we show the 3-month annualized percent change of subcomponents of services ex-shelter, shelter, and goods. We can note that goods price inflation and services ex-shelter have moderated considerably, but inflation in shelter remains sticky. Shelter was one of the largest contributors to inflation in June, growing at a 0.4% monthly pace and accounting for 70% of the increase within the core suite. However, this is relatively encouraging, as shelter is notoriously a lagging indicator, and leading shelter data has already begun to turn the corner.

While the June CPI report will likely be encouraging for the Fed in achieving its price stability mandate, this data point alone is unlikely to knock it off its path of another rate hike in July. Fed funds futures imply a 96% chance of a hike this month. The prospects for a second hike (as called for in the latest dot plot) remain up in the air. Futures are calling for a little over a twenty percent chance of a second hike by year-end. With that said, the Fed will remain data dependent, as the release of more economic data may prove to sway market expectations for additional tightening.

But at this point, the fed funds rate remains meaningfully above the neutral level, suggesting that the state of policy is tight and will likely get ever tighter. The Fed funds futures market is pricing in a path of additional rate hikes this year, with the curve peaking at around 5.6% in December, which is very much in line with the Fed’s most recent Dot Plot.

It may also be helpful to take a step back and see the bigger picture. The result of more than a year of aggressive rate hikes has led to considerably tight monetary policy. In the past, when the fed funds rate was excessively over the neutral rate, that has often started the clock for an economic recession in the U.S. Excessive tightening preceded recessions, which tended to show up 10-18 months after that point. Why the lag? It often takes time for monetary policy to permeate into the economy, often in the form of higher borrowing rates and reduced demand.

So, to summarize, the June CPI report showed both headline and core consumer inflation coming in a touch below consensus expectations. Within the core suite, shelter remains one of the largest contributors to inflation, still growing at a pace above the Fed’s comfort zone. The Fed, however, is focused on services ex-shelter as an indicator of ingrained inflation trends, which has moderated over the last few months. While this report is likely to be encouraging for the Fed, this data point alone is unlikely to knock it off its path of another rate hike in July. The Fed is expected to raise rates and keep rates well above neutral for the remainder of the year, and markets at this point don’t seem to disagree. Historically, past periods of tight monetary policy have not been favorable to the economy, often preceding recessions with a lag.

And with that, thank you for listening! And please don’t hesitate to reach out with any questions.

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