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Can the Federal Reserve claim victory over inflation?

August 25, 2022
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Inflation has been uncomfortably high this year.  In response to high prices, the Federal Reserve has stepped up by aggressively raising interest rates to slow growth and bring down inflation to its preferred level of 2%.  Since March, the Federal Reserve has raised the Fed Funds rate from 0% - 0.25% to 2.25% - 2.5% and is expected to raise rates an additional 1% by the end of the year.   Additionally, the Fed has been shrinking its balance sheet by not reinvesting treasury and mortgage-back security proceeds from principal payments to reduce liquidity and tighten financial conditions.   

The Fed’s actions are beginning to have an impact as inflation is beginning to show signs of easing. 

July CPI was unchanged on a month over month basis and the annual rate of change moderated to 8.5% versus 9.1% in June[1].

  • Retail gas prices have declined to a national average of $3.99 after peaking in mid-June at $5.10[2].
  • Mannheim Used Vehicle Value Index has slowly declined to 211.6 in August from its peak in January at 236.3[3].
  • FAO Food Price Index, a measure of international prices for a basket of traded agricultural prices, continued to decline in July for a fourth consecutive month[4].
  • Purchasing Price Index, a measure of selling prices received by producers for their output, declined in July for the first time since March 2020, although it is still up 9.8% on an annual basis[5].
  • 5-year Breakeven Inflation Rate is down to 2.7% (as of August 18, 2022) after peaking this year on March 25th at 3.59%. The breakeven implies what market participants expect inflation to be in the next 5 years, on average.  Additionally, 7-year and 10-year expectations have also come down after peaking in March and April[6].
  • The international global freight price index has continued its downtrend in July after peaking in September 2021. It turned negative year over year in July and June.  The index measures freight costs of 40 ft containers across eight routes[7].
  • Walmart, one of the largest retailers in the world, reported on its latest earnings call that it had cancelled orders and expected to discount items to resolve an inventory glut[8].
  • July airfares dropped by 9.6% from June although the average was up 27.7% from July of last year[9].

The good news for the Fed and the economy is many of these areas that had pushed inflation to record levels have started to rollover and are now showing signs of trending down over the coming months. 

How does housing impact the inflation indexes?

An area not showing signs of easing is the shelter component of both the Consumer Price Index (CPI) and Personal Consumption Expenditure Index (PCE).  This is important because the shelter component accounts for about one-third of headline CPI and 40 percent of Core CPI (CPI less energy and food).  For PCE, the shelter component makes up about half the size of CPI.  The two largest units in the shelter component are Owners Equivalent Rent (OER) and Rent of Primary Residence.  OER measures how much rent a person would have to pay equivalent to their cost of home ownership.  Rent of Primary Residence is simply the amount a tenant pays a landlord to lease a residential unit.

Since the beginning of the pandemic, homes values have increased at a historic rate rising by 41.2% since February 2020.  Even as higher mortgage rates seem to be moderating prices, July home values were up a healthy 18.24% over a 12-month period[10].  Yet, the housing component of CPI in July did not show a similar type of price increase and was up only 5.7% over the past year[11].  The current CPI data doesn’t fully reflect the appreciation in homes over the past two years. 

A study by the Federal Reserve Bank of Dallas estimates the shelter component of CPI tends to follow home prices by a 12 to 18-month lag.  Considering the delayed time to fully reflect higher home values, the Dallas Federal Reserve Bank estimates OER will increase from 5.4% in June 2022 to 7.7% in May 2023 before easing at the end of 2023.  Rent is expected to increase even more from 5.8% in June 2022 to 8.4% in May 2023[12]

A major concern is the shelter component could keep inflation stubbornly high over the next year and force the Fed to raise interest rates beyond expectations to wrestle inflation down to its preferred target.  Although, the Fed may choose to look past higher shelter costs especially if housing prices continue to cool and other components of inflation maintain a downward trend towards preferred levels.

Is the Federal Reserve’s work complete?

If inflation has peaked and is conceivably trending lower, should the Fed still be concerned about inflation?  Our feeling is that the Federal Reserve will continue to be laser focused on defeating this current stretch of high inflation.  By historical standards, inflation is still running near historical levels.  The July CPI was 8.5%[13] and the Federal Reserve Bank of Cleveland Inflation Nowcasting is estimating July PCE to be around 6.18%[14].  Given the Fed’s target rate is 2%, inflation still needs to come down a significant amount and the Fed will be reluctant to ease monetary policy until its clear inflation has settled back down near its target.  The good news is some areas are showing deflationary trends on a sequential basis.  Easing inflation pressures could provide the Fed flexibility to slow down the pace of interest rate hikes in the future.  A slower pace of rate hikes would be a positive for financial markets and risk assets since it would mean consumers and investors would be less concerned about the impact of higher rates on the economy.   

Ultimately, the Federal Reserve’s work is not finished.  We should expect to get further insight on future monetary policy when Fed Chair Jerome Powell speaks from Jackson Hole at the end of the week.      

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

[1] US Bureau of Labor Statistics. (2022, August 10). Consumer Price Index - July 2022.   

[2] YCharts, US Retail Gas Price for Week August 22 2022, https://ycharts.com/indicators/us_gas_price

[3] Mannheim Used Vehicle Value Index, https://publish.manheim.com/en/services/consulting/used-vehicle-value-index.html

[4] Food and Agricultural Association of the United Nations, FAO Food Price Index, August 5 2022, https://www.fao.org/worldfoodsituation/foodpricesindex/en/

[5] US Bureau of Labor Statistics. (2022, Augurst 11). Producer Price Index- July 2022

[6] FRED® (Federal Reserve Economic Data)

[7] Placek, Martin. (2022 August 18). Container Freight Rate Index 2019-2022. Statista.

[8] Banker, Steve. (2022 August 17). Walmart’s Supply Chain Woes. Forbes. https://www.forbes.com/sites/stevebanker/2022/08/17/walmarts-supply-chain-woes/?sh=11229a3913d0

[9] Silk, Robert. (2022 August 10). Amid Rising Inflation, Airfares Dropped Nearly 10% in July. Travel Weekly. https://www.travelweekly.com/Travel-News/Airline-News/Airfares-dropped-nearly-10-percent-in-July

[10] Zillow Home Value Index, FRED® (Federal Reserve Economic Data)

[11] US Bureau of Labor Statistics. (2022, August 10). Consumer Price Index - July 2022.  

[12] Zhou, Xiaoqing and Dolmas, Jim. (2022 August 16). Rent Inflation Expected to Accelerate Then Moderate in Mid-2023. Federal Reserve Bank of Dallas. https://www.dallasfed.org/research/economics/2022/0816

[13] US Bureau of Labor Statistics. (2022, August 10). Consumer Price Index - July 2022

[14] Federal Reserve Bank of Cleveland. (2024 August 24). Inflation Nowcasting. https://www.clevelandfed.org/our-research/indicators-and-data/inflation-nowcasting.aspx