Published 11 Sep, 2023
Despite the Federal Reserve’s aggressive monetary tightening, the downward inflationary trend has continued to reverse for the second month in a row. Having dipped tantalizingly close to the Fed’s 2% target, US inflation is edging further away once again.
Yet the increasingly mixed US economic signals released over the recent weeks may be the harbingers of a shift in the Central Bank’s decision process during the upcoming September FOMC meeting.
Truflation’s US CPI index has been steadily rising from a low of 2.1% on July 19 to 2.66% as of September 7. As such, we maintain our year-end US inflation forecast of 3.5%-4%. Let’s dig into the factors that drove inflation higher in August.
So far in 2023, US markets have barely registered the Fed’s aggressive monetary tightening. The S&P 500 index is up 17.6% year-to-date (YTD) as of September 5.
Graph 1: Market Summary > S&P 500
4496.83; up 672.69 (17.6%) Year to Date (5th of September)
Meanwhile, stronger-than-expected economic growth in the US has fuelled a rise in bond yields.
On September 5, the yield on the 2-year Treasury note ended the day at 4.94%, while the 10-year note was yielding 4.27%. These are now at their highest levels since June 2007, while the spread on the inverted yield curve, which we have seen since last summer, is beginning to tighten.
Graph 2: 10-2 Year Treasury Yield Spread; @-0.67% compared to long term average of 0.89%
Data Source: US Department of Treasury Yield Curve Rates
This continued market strength has prompted the Federal Reserve Bank of Atlanta to increase its Q3 GDP growth forecast from 5% to 5.6%. This marks a sharp turnaround from previous recession fears and could push the Central Bank to hike interest rates further at its September meeting in an attempt to put the brakes on economic growth. A strong economy also pushes out the timeline for any potential rate cuts, supporting a higher-for-longer narrative for US interest rates.
During his speech at the Jackson Hole Economic Symposium on August 25, Fed Chair Jerome Powell reiterated his commitment to the 2% inflation target and said interest rates may have to rise further to cool the economy – though he also promised to move forward with care.
Yet while Powell’s continued war against inflation may be music to the ears of consumers, it is not such good news for investors. The prospect of further interest rate hikes tends to weigh on risk assets, and in fact, the first week of September has already seen a small dip in the S&P 500. Further rate hikes could also seriously hurt P/E ratios, which tend to fall when inflation rises.
Currently, though, 93% of market participants are expecting the Fed to hold rates at the September meeting. Some 43%, however, think the Central Bank is not finished with its rate-hiking cycle and expect a 25 bps increase in November, according to the CME FedWatch tool.
The direction of inflation will be an important driving force for this decision. In particular, the Fed is watching the core inflation figure reported by the Bureau of Labor and Statistics (BLS), which remained significantly higher than the 2% target in July at 4.8%.
The stubbornly tight labor market is another key indicator. While the US unemployment rate has increased from 3.5% in July to 3.8% in August, it remains at historically low levels. Wages are also continuing to rise, albeit at a significantly slower pace. According to the BEA, wages in the US rose 4.8% in July, down from 6% in June and 5.8% in May.
While these datasets indicate a turning point in the market, it’s worth noting that wage increases continue to outpace inflation. In fact, consumers have enjoyed strong purchasing power for three months in a row after 25 consecutive months of negative purchasing power (where wage growth lags inflation). This, in turn, boosts consumer confidence and strengthens the economy.
Meanwhile, jobs growth remained strong in August, with the economy adding another 187,000 jobs – unchanged from July – while jobless claims dropped by 9,000 to 228,000. In particular, sectors with the most rampant hiring were health, leisure and construction. This suggests companies may still be failing to find workers to fill open positions.
Graph 3: Labour data; Unemployment and Wage & Salary percentage change vs year ago
Source: The Wage and Salary rate measures the percentage change in wages and salaries disbursements from government, manufacturing and service industries as reported by the BEA
The Unemployment rate measures the percentage of total employees in the United States that are a part of the labor force, but are without a job as reported by the BLS
This mixed data paints an uncertain picture, and this uncertainty is painful for both markets and consumers. As such, despite the Fed’s commitment to bringing down inflation, it is beginning to foster a sense of caution and hesitation among Americans, who simply want to be able to plan their future with some degree of certainty.
Truflation’s Consumer Confidence Index reflects this: down from 94.3 points in July to 91 in August, erasing the previous month’s gains. The Index of Consumer Expectation is also down from 106.8 points to 103.1 points. This drop in optimism reflects lingering consumer concerns over rising grocery and gasoline prices, as well as the recent dip in labor market conditions, with jobs becoming harder to get and wage increases slowing down.
Indeed, data by Challenger Gray, which we now publish on the Truflation website as part of our recently launched labor data stream, reveals that the number of job cuts has tripped from 23,697 in July to 75,151 in August, while DailyJobcuts.com has announced that August numbers doubled from July.
Graph 4: Truflation Consumer Confidence Trends
The drop in consumer confidence is also mirrored by retail sales, as reported by the US Census Bureau, and represents the majority of discretionary consumer spending. While retail sales are still rising – up 2.5% in July on an annual basis – this marks a significant decrease from January’s 8.7% annualized growth rate. Furthermore, when we remove the impact of inflation retail sales are, in fact, declining in August.
At the same time, retail inventory remains at its highest levels and the gap with retail sales is widening. This suggests we are likely to see further downward pressure on prices in the coming months.
Graph 5: Monthly US Retail Sales & Inventories in millions of $
Source: US Census Department; Advance Monthly Retail Trade Survey
Completing this picture is the record level of household debt, up 6% year-on-year and 0.1% versus the previous quarter at $17.063 trillion. A key driver for this is credit card debt, up 16% year-over-year and 5% versus last quarter. However, mortgage debt – the largest contributor to household debt – has decreased since Q2, though it remains 6% higher than a year ago. Perhaps consumers are taking on greater credit card debt to offset higher-interest loans.
Given this mixed economy picture, it is clear the Fed is not out of the woods yet, despite raising interest rates by 525 basis points over the last 18 months, which happens to be the fastest pace on record. The Central Bank has its job cut out navigating through this murky data to determine its next steps.
While inflation has come down significantly from over 9% to 3.2%, concerns remain that this trend may be reversing. The FOMC chose to increase rates again by 25 bps in July and the minutes from that meeting revealed that most members are concerned the inflation fight is far from over. Winning it could still require additional tightening action from the Central Bank.
Last month’s BLS inflation release marked a reversal of the downward CPI trend as inflation increased from 3% in June to 3.2% in July. We expect this trend to continue in August. Market expectations range from 3.3% to 3.9%, and Truflation’s model predicts that this figure will rise to 3.4%. This upward movement will certainly put increased pressure on the Fed to take action as it continues to target 2%.
In the post-pandemic era, we have seen goods inflation easing and a decline in housing inflation. However, with consumer spending booming, the last couple of months have reignited concerns over rising goods prices. We are also seeing an increase in housing given the higher interest rates. However, we are seeing a general slowdown, in particular in owned housing.
Overall, however, services inflation remains much stickier than goods inflation as a result of broad spending on an array of services combined with the tightness of the labor market.
Graph 6: Truflation Price Trends of Goods vs Services
Given the importance of the services sector beyond housing and food, reaching the Fed’s 2% inflation target will undoubtedly require an economic slowdown in the US. Most likely, this will take the form of below-trend economic growth and further softening in the labor market, and restrictive monetary policy will play an increasingly important role here.
Given these indicators and the anticipated continued increase in inflation, we do not expect interest rates to come down any time soon. Instead, the Central Bank will maintain its “wait-and-see” approach, and another rate hike in September remains on the table.
Indeed, Powell ended his speech at Jackson Hole this August with virtually the same line he used in the previous year's speech: "We will keep at it until the job is done".
Truflation’s data reveals that the most significant contributions to higher inflation in August came from gasoline, utilities, other vehicle expenses and other lodgings. Meanwhile, the biggest downward contributors were vehicle purchases, public transport and food.
Truflation's mission is to provide the most accurate inflation measurement in the market by leveraging 30+ data sources and over 12 million price points for goods and services. Truflation is not designed to measure BLS numbers as its index is based on just 80,000 items and uses a different methodology from ours. Rather, Truflation represents an alternative data source and one of the most comprehensive inflation measurement tools that can be reliably used to predict the BLS inflation estimate.
Over the past month, persistent wage growth, continued upward pressure on energy, gasoline and transport costs, and broader firming of material prices have been driving costs higher. Competitive forces have kept inflation under control to an extent, but soaring service sector prices are likely to keep inflation stuck above the Fed’s 2% target in the coming months.
The sectors exerting significant upward pressure on prices in August were gasoline, vehicle expenses, utilities, household durables and drugs.
Gasoline prices were one of the key drivers of the CPI’s upward movement in August, having risen 6.78% month-over-month (MoM). They remain 5.36% lower compared to last year, but this annualized figure has also been increasing.
This time, however, the increase in the oil price has nothing to do with strategic reserves or any political issues but is rather affected by market forces. In particular, this has been driven by the steady rise in oil costs since June and a production slowdown at some US refineries, which have been hampered by record summer temperatures.
Graph 7: Price of WTI Crude Oil per barrel
86.952 USD/bbl for September 6, 2023
Data Source: Weekly Petroleum Status from the Energy Information Administration
Rising oil prices, combined with increasing gas prices, have also pushed up utilities costs. The sector has seen a 1.62% MoM increase and is up 1.92% YoY.
In addition, this august was yet again one of the hottest August on record, contributing to inflation in this category. The heatwave drove electricity prices 0.66% higher MoM and up 5.61% on an annualized basis – though this rate has been continuously slowing. Increases were evident across other subcategories of the sectors, such as natural gas, fuel oil, water and other public services.
Graph 8: Truflation Utilities Category Price Trends
Other vehicle expenses are also driving up inflation with a 1.39% MoM increase and up 12.6% YoY. The last 6 months have seen a continued pattern of monthly increases amid rising interest rates. With rate cuts unlikely anytime soon, we expect prices in this category to remain elevated. It is also the biggest driver impacting auto loans, which are up 5% YoY and 1.3% versus the previous quarter.
Household durables and daily use items also pushed inflation higher in August, Truflation’s data shows. This was predominantly driven by household operational costs, which in turn are linked to the rising cost of labor.
Finally, the prices of prescription and OTC drugs have been consistently on the rise, increasing by around 0.4%-0.5% every month. We expect another 0.44% monthly increase in August, holding steady at 3.78% on a YoY basis.
These price increases have come on the back of a new federal law, which requires companies to pay a Medicare rebate if they increase prices above the rate of inflation. Other drivers include changes in the insurance coverage and the complex rebates often hidden from the public view. As a result, drugmakers have been launching new, more expensive drugs in an effort to maximize sales before Medicare has the chance to bargain for more affordable prices.
In August, four main categories continued their deflationary trend: housing, food, vehicle purchases and public transportation.
Housing is a key sector that makes up nearly a quarter of total household expenditure and for which Truflation now publishes real-time data streams on its website.
Although the long-term outlook is now considerably clearer, with house prices expected to fall as significant new supply comes onto the market and high interest rates take their toll, the short-term outlook remains cloudy. In August, we expect housing inflation to continue cooling – a trend we predict will persist until interest rates start to decline.
This downward trajectory is driven by owned housing, where monthly price increases have slowed from 0.5% in May, 0.72% in June and 0.1% in July to 0.06% in August. On an annualized basis, housing inflation has dropped from 9% in January to 2.83% in August.
Graph 9: Truflation Housing Category Price Trends
The total number of new residential home sales has gradually been dropping from 4.3 million in January to 4 million in August, according to the National Association of Realtors. Zillow, Trulia and Redfin are reporting similar consistent trends. However, this reduction in home sales is offset by a steady increase in the median price.
The impact of rising mortgage rates appears to be curbing demand for new homes, with 30-year fixed-rate mortgage rates current at 7.18%, as of August 30 (according to Freddie Mac). These elevated rates are likely to hold given the uncertainty regarding the Fed’s monetary policy plans. Soaring tax premiums have also put pressure on the owned property segment.
In addition, we are seeing significantly more supply coming onto the market. The number of newly completed residential properties has hit new highs, with 10.3 million units completed YTD, which marks a 7% increase from last year. This will apply further downward pressure to house prices for the first time in a long while.
Graph 10: Housing Supply; New Residential Permits, Starts and Completes in 000s of Units
Source: US Census Bureau / New Residential Construction Report (all in 000s of Units)
Looking further ahead, it is increasingly clear that with high interest rates, increased supply, and demand cooling, house prices will continue to trend downward before we see an upward trend again.
The transport sector – for which we also now publish a detailed data stream on the Truflation website – is another key downward contributor to inflation. In particular, this is coming from vehicle purchases and public transportation.
Demand for new and used cars has significantly waned since the early months of 2023 as financing costs have soared. Excess inventory in the market has also placed downward pressure on vehicle prices in the last five months. Vehicle purchases are down 1.22% MoM and 3.4% YoY.
Graph 11: Truflation Transportation Category Price Trends
Vehicle dealers continue to grapple with excess supply, with auto retail inventory rising to $221.1 billion in June 2023. As inventory levels outstrip demand, we expect prices to keep falling for the next quarter. In addition, we are about to enter a cooling period for the car market, which tends to trend lower towards the end of the year.
Graph 12: Motor Vehicle and parts dealers Retail Sales and inventories in Millions of $
Source: US Census Department; Advance Monthly Retail Trade Survey
Public transportation, meanwhile, has seen a decline of 6.09% MoM and 13.02% YoY. It is, however, not surprising to see public transportation prices, which include planes, trains, taxis and subways, coming down in the summer months, with less business travel in July and August.
Meanwhile, post-pandemic revenge travel, recreation and hospitality spending, which contributed to improved economic performance in Q2 and early in the summer, is now losing momentum. TSA checkpoint daily travel numbers are down by 5% MoM in August, but still up 11% versus a year ago.
Beyond passenger numbers, corporations are also increasingly reporting that customers have become reticent to spend amid gloomier prospects as higher interest rates take their toll.
However, we expect to see further price increases down the line, particularly when it comes to domestic air travel, as we enter into the fall and winter holiday season. Fares will peak in late November and early December as travelers book their last-minute Thanksgiving and Christmas trips. This is also when we expect airfares to virtually match pre-pandemic prices.
The last significant contributor to the downward pressure on inflation was food, which is down 1.1% MoM. However, on an annual basis, food inflation is still sitting at 1.68%. The recent slowdown is evident in both grocery prices (food at home) and the cost of dining out (food away from home).
Graph 13: Truflation Food & Beverage Category Price Trends
We are not surprised to see this slowdown in food prices as consumer confidence falters. In part, this monthly drop can also be attributed to the summer months, which historically tend to see a marginal dip.
However, while this easing is a relief for struggling consumers, let's not forget that we are still talking about a 1.7% YoY increase on top of 9.9% food price inflation a year ago.
Other sectors seeing deflationary trends include apparel, down 0.7% MoM on the back of a seasonal trend and weakening demand. We are also seeing increased competition for consumer’s wallets as retailers kick off seasonal sales earlier than usual. Communications and alcohol and tobacco are also driving inflation lower.
We believe inflation will continue to see marginal increases in the next couple of months before coming down towards the end of the year. We maintain our year-end projection of 3.5% to 4%.
In the short term, the increases will continue to be driven by the tight labor market and marginal increases in utilities, gasoline and the service based categories. S&P Global’s latest PMI survey re-enforces these stubborn price pressures, which are now accompanied by the near-stalling of business activity. As such, third-quarter numbers are pointing toward faltering economic growth and subsequent price pressures as we head into Q4 and Q1 2024.
Graph 14: US annual economic growth and the PMI.
Source: S&P Global PMI; S&P Global Market Intelligence (PMI covers manufacturing only prior to 2009 but manufacturing and services thereafter).
However, with a strong likelihood of one more interest rate hike later in the year, and a softening in the labor market as a result of an overheated economy, we expect to see a continued drop in consumer confidence. This, in turn, will bring down prices in the housing category and curb consumer spending, helping to keep inflation in check over the long term.
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Truflation provides a set of independent inflation indices drawing on 30+ different data partners/sources and more than 12 million product prices across the US. The indices are released daily, making it one of the most up-to-date and comprehensive inflation measurement tools in the world.
Truflation has been leveraging this measurement tool to predict the BLS CPI number. Since Truflation initiated coverage, four predictions were spot on, with all but one deviating by no more than 20 basis points. However, Truflation’s own US CPI index is currently much lower than the government’s reported inflation figure.