E-piphany

Okay, I will admit that I came into today thinking ‘this is one of the more low-stress releases in quite a while. We know headline inflation is going to be negative, and it’s just a question of whether core is 0.20% or 0.26%.’ The Bloomberg consensus was for -0.12% (seasonally adjusted) on headline CPI, and +0.23% on core CPI. That core CPI forecast would annualize to 2.8% or so, clearly indicating that inflation hadn’t fully returned to target but also not super alarming. The swap market was aligned with economists’ forecasts.

Wow, were we collectively wrong on that!

The conspiracy nuts are going to have a field day with this, even though the Federal Reserve has nothing to do with the Bureau of Labor Statistics. We get a new Fed Chairman and wham! Inflation suddenly has a sharp, surprising drop. I don’t think we need to get involved in that. There are some weird things with this number, and they all sort of got weird in the same direction, but I wouldn’t call them suspicious. However, the conspiracy nuts will point out – rightly – that there’s nothing other than gasoline that feels like its price is declining. And yet…the actual data for today showed a m/m decline in headline cpi of -0.42% and a decline in core of -0.02%.

That is a massive miss in core and the biggest decline – outside of March, April, and May 2020 – since March 2017. And in March 2017, the dip was caused by a 7% single month decline in Wireless Telephone Services, caused because the sudden shift to ‘unlimited data’ plans blew up the hedonic adjustment for data…going from 5gb to ‘infinity’ caused issues. (I wrote about that in How the BLS Methodology for Wireless Plans Exaggerated a Small Effect). Before that, January 2010 when post-housing-bubble home prices and rents were in retreat and almost turning the y/y core inflation negative (it got down to 0.6%). Before that, 1982. So, an outright decline in core CPI is rare, and especially with the overall trend firmly in the too-high-for-the-Fed zone, this is a large outlier.

The last-12-core numbers chart looks more like headline CPI than core CPI. That’s partly due to the Oct/Nov dips caused by the way the BLS handled the shutdown, and the April spike due to the payback on the rental survey. But let’s say that if you were selling straddles on core inflation, this is drastically more vol than you were pricing.

So, we go hunting for culprits. Breaking into the 8 major subcategories suggests some places to look.

A lot of the Transportation decline is of course gasoline, but the gasoline drag was pretty much spot-on what had been in the forecast. The forecasts had been looking for an 0.35% difference between headline and ex-food-and-energy CPI, and we actually had 0.40%.

One part of the explanation – as every part of a big miss on core must be – comes from rents. Primary Rents were +0.15% m/m, and OER was +0.24% m/m. Last month, those were +0.36% and +0.30%, which were not drastically far off from the current trend. But this month, the y/y decelerated again.

Airfares was +0.21% m/m; that’s a place I looked as a possible culprit since while it’s in ‘services’ these days it’s mostly a pass-through for energy and with energy dropping sharply I thought it was possible. It hasn’t happened yet, though. Lodging Away from Home was a surprising -2.32% m/m (surprising because the assumption is that the World Cup would keep it bid for another month), but LAfH moves around a lot and we can’t put it all at the feet of the hotels. Used Cars was -0.23% m/m, and New Cars -0.02% m/m, and that’s part of it too but hardly big enough to call it a major surprise.

So we continue to investigate but note that Median CPI is likely to be low also. My early estimate is +0.156% m/m, although I note that the median category is probably one of the regional OERs so I’ll be off by a little bit at least.

If that sort of Median CPI was repeated 11 more times, it would mean y/y Median CPI would be at 1.9%, well below the Fed’s target (since Median is typically above core by 0.25%-0.50%). Color me skeptical.

It’s worth noting that Core Goods inflation did not abruptly collapse. My thesis is that if the Fed’s going to get back to target, and I’m even vaguely right about housing, then you really need to see core goods to be around zero to have a good shot of getting there. And we aren’t really even sniffing it yet.

Or, alternatively, we would want to see SuperCore drop sharply. There’s no obvious sign of that, but it does bear noting that Core-Services-ex-Housing was -0.21% m/m.

That was the lowest supercore since 2020, and before that the Cell Phone Services thing in 2017.

Let’s look, since I’ve mentioned it twice now, at cell phone services.

Three things bear pointing out here. First, note the general deflation in cell phone services prices. Yeah, yeah, I know your contract hasn’t gone down in price much but you’re getting more and more quality. It’s a pretty steady trend. Second point: note that the upward divergence in 2023 almost exactly mirrors the downside divergence in 2026 before this month. The shapes are actually almost congruent. You get that frequently in a year/year rate when an item spikes in price, and then that spike falls out of the y/y. But this isn’t a year/year rate. This is an NSA price index. I can’t think of any reason for that weird phenomenon…it must be methodological somehow. Third point: this month’s spike is clearly an outlier. That doesn’t mean it isn’t real, but it does mean I don’t expect it to be repeated. For scale, note that the change is about 1.5 points on the index. The 2017 decline was 3.7 points. Odd, and I can’t explain it yet, but again: unlikely to be repeated. For what it’s worth, this is not an irrelevant weight: “Telephone Services” in the CPI carries a 1.5% weight. Thanks, “screenagers!”

I always survey the biggest-gainers and biggest-losers monthly change list, using the breakdown the Cleveland Fed uses for Median CPI. Because they are the tails, they don’t affect the median but they do affect core. This month, the biggest losers list included Lodging Away from Home (already mentioned), Jewelry and Watches (small weight), Communication (just mentioned), Infants’/Toddlers’ Apparel (small weight), and … Motor Vehicle Insurance, which declined at an annual rate of 22%. Odd?

Car insurance is 2.7% of CPI, so it is noticeable. Does this make sense? It’s possible, I suppose, because of the decline in used car prices…and, perhaps, there’s an effect from mass deportations here, since if you have fewer uninsured motorists then the cost of insurance should fall. I did not see it coming, and unlike the telephone thing I can imagine there could be some modest further declines ahead if I’m right about the causes.

So: housing, cell services, car insurance. Definitely some outliers. Rents will probably recover to get back to a more-normal run rate of +0.25%/month – after all, even with this surprise we’re right on our model.

Is it only outliers? The Enduring Investments Inflation Diffusion Index declined, so there was some narrowing of the inflation advance, but it didn’t exactly plunge. I’m going to say then that this was more the outliers than a fundamental shift of inflation momentum (at least, that’s what I think right now!)

From the Fed’s perspective…from Warsh’s perspective…this is obviously very welcome. There is little chance of any hike in US policy interest rates this year. There wasn’t much chance of it before this number either, since the new Chairman’s stated preference is for a smaller balance sheet and lower interest rates (both of which policies retard inflation, in different ways). But there is even less of a chance of a rate hike now. However, it does bear remembering that as we move later in the year, the core and median y/y numbers are going to rise, simply from base effects, and especially in October and November when the shutdown effects fall out. Ergo, it may be difficult to price out all hikes from the yield curve, unless the economy starts to visibly weaken.

Let me leave you with one last chart, to remind you that it is premature to declare victory over inflation.

M2 y/y growth is back to 5.6% y/y, and climbed at a 7% annualized rate over the last 6 months. The balance sheet has actually been growing, not shrinking, since December. Is that Powell’s last middle finger to Trump? In any event, that’s one reason that money growth is back in the range that was normal prior to COVID. But during that pre-COVID period, there were unique trends that held inflation lower than it otherwise would be: demographics and globalization being two of them. Those effects have reversed, and consequently (I’m sorry but I can’t say it often enough) a 6%ish growth in the money supply is no longer consistent with 2% inflation. Either the Fed needs to get religion (and Warsh has the hymnal open, but it’s not clear yet if anyone is going to sing along with him) and shrink the balance sheet to rein in money growth, or inflation is going to remain stubbornly resistant to a return to 2%. Phones and car insurance can’t do it all.