Inflation: Too Hot?

The Fed's preference is also in part due to the PCE accounting for changes in how people shop when inflation jumps (e.g., consumers shifting away from expensive national brands to less expensive store brands). In addition, the CPI only tracks out-of-pocket consumer medical expenditures, while the PCE also tracks expenditures made on behalf of consumers, including employer contributions. Also significant is the weight of shelter in each index; with more on that below.

Because inflation has historically come in waves—and courtesy of the lessons (hopefully) learned throughout the 1970s—the Fed has pushed back on what was a high probability of a March start to rate cuts as recently as early last month. What could be particularly troubling to the Fed is the significant jump in the share of CPI categories with inflation rates running hotter over the past three months relative to the past 12 months.

In the CPI's shelter category, the two components with the largest weights are RPR and OER. The former's weight in CPI is just less than 8% while the latter's is much larger at 25%. That discrepancy means OER tends to receive more attention; if not for its weight, then surely because of how it's calculated. OER is an imputed metric; each month, the Bureau of Labor Statistics (BLS) asks homeowners how much they think they can earn if they were to rent out their home in a competitive market, then uses that to calculate the growth in "rents."

With home prices having reaccelerated, it's not difficult to see why OER has taken longer to slow down, which has gone against the consensus' call for shelter costs to fall quickly and accelerate the disinflation process. We often hear from reports, analyses, and conversations that it will happen "any month now." As long as home price growth stays elevated, though, we actually see scope for a slower and choppier path lower for OER.

Looking at the chart below, there is a lagged relationship between actual home price growth and OER. Yet, the rub is twofold: it's not perfect, and if we're comparing the current cycle to prior spikes in OER (especially the late 1980s), home price growth at the current pace would be consistent with a much slower pace in OER growth. That hasn't happened yet.

That supports the argument that the Fed might not be as nervous over the January CPI stat. That said, however, a good chunk of the public watches CPI and uses it as the preferred inflation gauge, so it's tough to believe that the Fed will shun the index altogether.

If anything, the main takeaway here is that the disinflation process continues to be choppy. The underlying data are all telling different stories, with the goods sector's disinflation and/or deflation, and the services sector's stickier inflation. Overall, though, the aggregate indexes are not yet convincing the Fed that its 2% target can be reached (and then sustained) just yet; evidenced by what FOMC members have said lately. Investors might argue otherwise, so that prompts us to remind readers of the following: there is often a big difference between what Fed watchers think the Fed should do and what the Fed will actually do.