Last Thursday, the Bureau of Labor Statistics (BLS) reported October U.S. Consumer Price Index (CPI) inflation of 0.4% month-over-month (m/m), 0.2 percentage points (ppts) lower than consensus expectations. Markets reacted violently, with the 10-year U.S. Treasury note recording its largest single-day fall in yield (30 basis points) since March 2009, and second largest fall since 1987 (source: Federal Reserve daily H.15 data).
In our view, this market reaction appeared outsize relative to the extent of the CPI surprise. Since the late 1990s (when Bloomberg started recording consensus forecasts), consensus has tended to overestimate the monthly change in headline inflation roughly 30% of the time, while realizing a negative surprise of 0.2 ppts or more around 10% of the time – meaning it’s not a shockingly rare event. And yet, we subsequently witnessed one of the largest recorded bond market moves in response to a CPI report. Last Thursday’s market reaction was second only to 18 March 2009, when the Federal Reserve, on the same day as the CPI data release, announced its first round of large-scale U.S. Treasury purchases in response to the global financial crisis – a program that was later called QE1 (i.e., the first round of quantitative easing). On that one day in March 2009, the 10-year Treasury yield declined 50 basis points (bps).
Looking beyond Treasury markets to broader financial conditions (i.e., movements in equities, rates, the U.S. dollar, and credit spreads), we still observe the market reaction to last Thursday’s CPI release was one of the largest in decades. While position “stop outs” (typically via stop-loss orders) and challenged market liquidity ahead of the U.S. Veterans Day holiday both likely played a role in the dramatic market reaction, we think it’s worth reviewing the CPI report in the context of our broader economic outlook. We have five takeaways:
First, The October CPI release was (finally) a welcome sign that U.S. inflation is likely to moderate. While the October CPI report didn’t materially change our prior outlook on inflation moderating, it arguably did increase our confidence in that forecast. Even prior to the October CPI release, our 2023 inflation forecast embedded moderating inflation across goods categories, including energy and food, although we also forecast still sticky services prices (rents and other services inflation, which tend to be sensitive to wages) would ultimately keep 2023 year-end U.S. core inflation running around 3.5% to 4% – a pace well above the Fed’s 2% inflation target. However, up until the October CPI report, the input price moderation that had been evident across various other price measures (e.g., ISM (Institute for Supply Management) Prices Paid index, logistics costs, and global producer price measures) was not clearly apparent in the CPI. Many observers attributed that apparent slight discrepancy to corporate profit margin and consumer demand resiliency, which in turn raised the risk that the Fed would have to do more to cool the economy. The October CPI report arguably reduced these risks, solidified forecasts for a step-down in the pace of tightening at the December Fed meeting (similar to market consensus, we expect a 50-bp adjustment), and reinforced our outlook for the fed funds rate to reach the 4.5% to 5% range before the Fed pauses.
Second, a moderation in inflation isn’t likely to be a straight line. The October CPI print was a relief, but it’s too early to declare victory. In fact, we suspect some of the goods categories that were particularly weak in October will temporarily re-accelerate. Indeed, in the months ahead, the prices of used cars, furniture, and other household items may reverse October’s decline as relatively price-insensitive demand related to damage caused by Hurricane Ian temporarily reverses the recent trend. Furthermore, some of the discounting could have been related to Amazon’s second “Prime Day” in October and knock-on retailer discounting, which may reverse somewhat in November. (For more details, please read our blog post, “What’s Behind the Slowdown in U.S. Inflation.”)
Third, and related, going from 8% to 4% inflation is likely to be easier than going from 4% to 2%. Once we get through the demand boost from the holiday shopping season and hurricane damage replacement, headline U.S. inflation potentially could moderate from 8% to 4% relatively quickly. Over the last year, energy and used cars prices increased 40% to 50% at their peak, contributing over 4 ppts to headline inflation. More recent price declines in these categories should similarly help moderate overall inflation. However, the stickier categories may take more time. Rental inflation isn’t likely to more fully reflect the moderation in alternative data on rental listing prices and new lease rents until 1Q of next year. Furthermore, monthly rental inflation has moderated but is still running above pre-pandemic averages (for example, the Zillow Observed Rent index is still growing at a roughly 6% annualized pace m/m, down from a peak of 27%, but still elevated versus a roughly 5% pre-pandemic average). Similarly, still elevated wage inflation is likely to continue to support inflation in non-shelter services until the labor market starts to contract.
Fourth, the implication of price drops is not universally good news for the economic outlook. Indeed, a surprisingly weak inflation reading likely reflects softer consumer spending, and increased margin pressures for the corporate sector. Researcher Alberto Cavallo documented (in a 2018 paper published by the Kansas City Fed) that the “Amazon Effect” within the retail market has virtually eliminated “menu costs,” increased price flexibility, and resulted in a much higher price sensitivity to aggregate macro shocks. As a result, the fall in retail prices in October, after markups had held up surprisingly well in recent quarters, isn’t a good sign for consumer spending.
Fifth, the Fed’s Senior Loan Officer Opinion Survey (SLOOS) data reported last week appeared recessionary and falling credit growth is deflationary. Large and small banks reported tighter credit conditions across the various loan categories, including commercial and industrial (C&I) and commercial real estate (CRE) loans, while also reporting a notable drop in mortgage lending demand. Overall the report was consistent with tighter credit conditions, which should weigh on credit volumes. Historically, trends in credit conditions of C&I loans in particular have usually led aggregate capital expenditures by around 1 quarter, and the latest data is consistent with our forecast for a larger contraction in non-residential investment starting early next year.
What’s the bottom line? Overall, the October CPI report was a welcome sign that U.S. inflation is likely to moderate as expected. Forecasters, including us, have been shaken by inflation over the last few years as the reported levels have repeatedly surprised on the upside. As such, although the usual leading indicators were pointing to some moderation, the fact that we actually got it is a relief, and in the near term this should take some pressure off the Fed. While the October print may have reduced the likelihood of the Fed needing to take rates ever higher still, getting inflation all the way back to 2% will very likely require a period of restrictive policy (and a recession). As a result, although a Fed pause is likely, it’s still too early to expect a full pivot toward rate cuts.
Source: Tiffany Wilding, PIMCO North American Economist