Good morning! Today is Federal Reserve day. It is widely anticipated that Jay Powell and the Federal Reserve will announce that there will be no rate increase at this time, but there may be one in the near future. We agree with this expectation and believe it would be a wise decision, especially considering yesterday’s inflation report. On a more exciting note, the first episode of Unhedged’s podcast, hosted by Ethan and featuring the lively Katie Martin, was released yesterday. Don’t miss out on it! Also, feel free to email us with your ideas at [email protected] and [email protected].
Speaking of inflation, the question now is how far it will fall. In our previous newsletter, we discussed how inflation’s trajectory had improved, even though the issue was not completely resolved. The decline in shelter inflation had begun, as evidenced by two months of falling rents, and prices for goods, except for used cars, had stopped rising.
Fortunately, these trends continued in yesterday’s May Consumer Price Index (CPI) report, providing further confirmation of the inflection point. While there was an increase in core inflation, we disagree with the claim that the Federal Reserve has made little progress in reducing underlying inflation. When you remove used cars and rents from the equation, inflation actually looks much better.
It’s important to note that data adjustments are designed to identify turning points in the underlying inflation rate, not to dismiss the issue of rising prices. Currently, there are valid reasons to exclude rents and used vehicles from the analysis. The Manheim used-car price index, which is based on wholesale car auction data, typically closely tracks the CPI used cars and trucks component. However, a surge in demand in January, captured by Manheim in February and March, is only now being reflected in the CPI. This is why CPI used cars has increased significantly in the past two reports. As more cars enter the market, the Manheim index has started to decline, and we can expect CPI used cars to follow suit.
The story with shelter inflation is familiar by now. CPI takes into account both new and existing leases and lags behind real-time market conditions by about nine to twelve months. The recent CPI report showed a slower pace of rent inflation for the third consecutive month, although the superficial increase in CPI shelter was due to volatile hotel prices, not rents. Considering the year-over-year trend in CPI rent and the more timely Zillow rent index, it appears that there will be more positive news to come.
However, the Zillow new rentals index does give a warning signal. While it initially decreased sharply, it has recently started to accelerate again. This suggests that there is a limit to how low inflation can fall without a decline in economic growth. Even if CPI shelter stabilizes around a 4-5% annual rate, as suggested by the Zillow index, it would still be higher than the long-term average of 3%, which is too high for the Federal Reserve.
This point extends beyond shelter inflation. Unless traditional economic models are fundamentally flawed, strong economic growth sets a bottom limit for inflation. Falling inflation improves consumer purchasing power, sustaining spending and allowing companies to pass on price increases. As Neil Dutta of Renaissance Macro explained, falling inflation is like a tax cut for households and leads to an increase in real wages. This is good for growth and demand, preventing companies from cutting prices.
This raises the question of how the Federal Reserve should feel about inflation running at, for example, 3.2% or 2.9%. Should central bankers prioritize growth or stick to their inflation targets? (Ethan Wu)
Moving on to another topic, let’s take a look at falling earnings. The chart above shows the annual change in nominal GDP growth and S&P 500 earnings growth. Earnings growth has recently fallen below zero, which may raise concerns for some.
However, there are two arguments against interpreting the recent decline in earnings as a major issue. First, while a decline in earnings is a necessary condition for a recession, it is not always sufficient. In past mid-cycle slowdowns, such as those in the late 1990s and 2015-16, earnings went negative but the economy managed to avoid recession.
Secondly, the reason for the current decline in earnings is the fact that they were artificially high during the pandemic due to increased demand and profit margins. In the two decades prior to the pandemic, earnings growth averaged around 6.4%. Even after recent declines, earnings are still above that average over the past three years.
While certain companies may experience a significant decline in sales and earnings due to the unique circumstances of the pandemic, this may not be a widespread phenomenon throughout the economy. The chart shows that in the past, periods of above-trend earnings growth were followed by below-trend earnings growth. However, it’s important to recognize that this is simply part of the economic cycle and that earnings peak just before the cycle turns. Furthermore, it’s possible that the recent period of high earnings was an anomaly fueled by fiscal spending, and the next phase is a reversion to the long-term trend rather than a crash below it.
It’s worth considering the possibility that a decline in sales, margins, and earnings could become self-perpetuating, leading to further decreases in demand and profits. However, it’s not clear that this scenario will occur this time. Nevertheless, it’s important to keep it in mind.
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