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Those who follow boxing are familiar with the phrase “the tale of the tape.” It is used to make an objective comparison between the two combatants in the ring.
When it comes to inflation, the two “combatants” are overall inflation, also called headline inflation, and core inflation.
In basic terms, inflation is the result of an overheating economy. The consensus to combat this is raising interest rates, which will slow economic growth and lead to lower inflation. There are, however, risks associated with this approach, the main one being a recessionary environment.
Markets rallied the last few months on the notion that inflation will continue to cool, along with recent comments from FOMC Chairman Jay Powell stating, “The disinflationary process has begun.”
While it has begun in some sense, recent data suggests the Fed may need to take additional measures. Even though headline inflation continues to decelerate, core inflation remains far too high. This has spooked markets, as indicated by the recent uptick in volatility.
My commentary this month will focus on the difference between these two types of inflation.
Headline Inflation
Headline inflation is the raw inflation number reported through the Consumer Price Index (CPI). It tells us the cost of purchasing a fixed basket of goods and helps determine how much inflation is occurring in the economy. It does not remove highly volatile aspects that can change with seasonality, so one should expect a larger variance with this number.
The data shows that headline inflation has decelerated since June of 2022, which was desperately needed.
As seen on the chart below, the various CPI components are well off their peak levels, minus shelter, transportation services, and medical care services.
While progress has been made, certain parts are largely out of the Fed’s control, which will likely lead to more volatility ahead. I am not trying to rain on anyone’s parade, as we should acknowledge the progress that’s been made. At the same time, we need to recognize the warning signs that linger.
Core Inflation
Core inflation measures the change in the costs of goods and services minus food and energy prices. The rationale is that these commodity prices are extremely volatile, which can skew inflation data over shorter periods. Many economists believe that core inflation is a more accurate indicator.
The key is to analyze the difference between goods and services within core inflation. Goods are physical and tangible items we purchase (e.g., cars, clothing, electronics), and services include everything else, ranging from transportation services to medical care.
While both goods and services are vital to the consumer, they are at times driven by different factors. The pandemic is a great example, as the price of goods skyrocketed due to shortages caused by the global economy practically shutting down for several months. Prices of toilet paper, cars, and food went through the roof!
The price of core goods has decelerated as supply chains continue to improve with the pandemic largely behind us. The troubling sign is the steady increase in wages, which is, in turn, pushing up the cost of services.
The chart above helps illustrate the divergence between core goods and services, specifically over the last 12 months. So, while we see improvement in core goods prices, services (mainly wages) are still accelerating as the labor market continues to defy logic and remain red hot in the face of significant interest rate increases in 2022.
The question for the Federal Reserve is how much more it will need to raise interest rates to cool the labor market. What if the labor market continues to rise even in the face of future rate hikes? What if interest rates rise too much, pushing us into a deep recession? Many questions remain, and it will likely take a few quarters for this situation to play out.
Given how aggressively both stock and bond markets rallied from October to the end of January, I would expect more volatility until we get a better sense of things from a labor market perspective.
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