Falling Input Costs Seem to Point to Further Deceleration in U.S. Inflation

Last Edited by: LPL Research

Last Updated: October 12, 2022

Markets, Central Bank, Consumer Confidence: Historic Moves Across the Globe

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Podcast Intro:

From LPL Financial, welcome to Market Signals.

Marc Zabicki:

Good morning, everyone. Welcome to this edition of the LPL Research Market Signals Podcast. My name is Marc Zabicki. I am joined today by Fixed Income Strategist Lawrence Gillum. Lawrence, how are you doing this morning?

Lawrence Gillum:

I'm doing well, Marc. It's a pretty volatile day in the markets, which we'll, I'm sure we'll talk about, but other than that, can't complain about too much.

Marc Zabicki:

Indeed, I think we could say every day is volatile in the year 2022, at least so far. We are recording this on Tuesday, October 11. For those who may view this video or listen to the podcast after that date, so recording Tuesday, October 11. And we did indeed have a lot to talk about. In terms of market activity. We certainly have a lot to talk about in terms of upcoming numbers this week.

 

Particularly CPI and PPI numbers. And also some, you know, potential, you know, Federal Reserve thinking that may be going on in Washington, D.C., specifically as folks from the IMF and World Bank gather in Washington, D.C. So, before we get into that taking a look back at the previous week in terms of market activity. Last week started out fairly well for you know, markets in general, particularly U.S. markets based on some comments, if you will, from the United Nations, that central bankers may in fact be going too far, which likely inserted a probability that central bankers perhaps could pause. And what I mean by that is that, you know, I think prior to that comment from the U.N. I think the general thought from market participants was, you know, the Fed is going to go full bore, et cetera, et cetera.

 

And as we see some disjoint happening in capital markets, particularly in the U.K. And Europe we, you know, people inserted the probability that maybe the Federal Reserve or central bankers could in fact pause or basically came to the notion that the probability that the central bankers pause is not in fact zero. So that's perhaps what we saw a little bit of early last week. That was followed up by some definitive downside pressure on Friday based on a better-than-expected jobs number where we got, you know, the unemployment rate in the U.S. fell from 3.7% to 3.5%. Obviously, what the Fed is doing in terms of its work is trying to impact the jobs market and take some of the tightness out of the U.S. Jobs market that really has not yet quite come to pass at a sustainable level.

 

So, some modest reprieve and markets globally last week, but generally just continues to be a weak market, continues to be a market that's impacted most generally by Federal Reserve policy and the expectations around inflation. If I take a closer look at fixed income, Lawrence, this is your area of expertise, your wheelhouse, certainly. So how would you characterize fixed income markets over the last week?

Lawrence Gillum:

Yeah, it's been a rough market continuing with rates higher across a lot of the different treasury yield curve tenors. But one thing I would point out is that interestingly, the high yield bond market, so the most riskiest debt in the fixed income universe, had a positive return last year, whereas the safest fixed income markets to the treasury index were down a bit last week.

 

So, from my reading it, you know, it looks like this is still a rate driven market and not a credit driven market. So, we don't see credit risks on the horizon that are kind of flashing any sort of warning signs, and that certainly showed up in performance last week anyway.

Marc Zabicki:

Yeah, certainly, I mean, it's about the Fed all about the Fed 24/7 seemingly, and we talked, I think last week about, you know, the relative strength in balance sheets and much of the high yield space and the lack of refining, refinancing need there. So maybe some of that activity was present last week. In terms of commodities, generally a space that we don't like very well. And I think we'll touch on the OPEC+ production cut, 2 million barrels a day caused, you know, a spike in oil prices and a spike.

 

And natural gas continues to be relatively strong in terms of its pricing. Lifted, certainly, the energy portion of the commodity index and also the overall commodity index in terms of the Bloomberg benchmark. Last week, we certainly had a conversation around what was going on in the U.K. around the politics. You know, it's balance sheet and what political leaders are doing in order to manage that. You know, some of the budgeting is going on in the U.K. and some of the consternation around that caused, you know, clearly some distress in the gilt market and also for the British pound. Last week, you know, Lawrence, turning to you on this subject you know, how should investors think about, you know, what went on in the U.K. and the gilt and the pound last week.

Lawrence Gillum:

Yeah. And it's continuing over into this week as well. And, you know, after Liz Truss's government announced that this mini budget that was you know, was going to cut the top income tax bracket for the highest earners, you know, the bond market reacted negatively, the pound reacted negatively relative to the U.S. Dollar. Thankfully they did walk back some of that announcement last week, which did provide some sort of kind of recovery in those markets. But if we're looking at what the gilt market is doing today, and yesterday, in fact, we saw another broad base selloff in the gilt markets where we saw, you know, 10-to-50-year maturities up 25, 30 basis points over the course of a day. So, there's still stress in that market.

 

I mean, you could argue that this is a self-inflicted wound coming out of that market, but, you know, given the rate hikes that we're seeing, you know, globally, I think that plays into it as well. But you know, this is an area that we continue to watch and see if there's any sort of spillover impacts into other markets.

Marc Zabicki:

Yeah, yeah. Certainly not helping things in terms of capital markets what's going on in the U.K. We note here, German factory orders basically just a message around the general weakening of eurozone economies. You know, probably we would add to that distress coming out of Credit Suisse and other places, you know, make the eurozone not too attractive in terms of a place to put your money, given the way we think of it as a Strategic and Tactical Asset Allocation Committee.

 

So still favoring the U.S. on a relative basis versus the rest of the world. I mentioned OPEC+ cut 2 million barrels a day. Obviously, we're not going to look at an oil price chart today, but, you know, West Texas Intermediate has in fact spiked up on that news. The Bank of Japan continues to struggle with a general weakness in the yen and basically came out and said it was going to continue to fight that battle. And then just I think almost to a person in terms of Federal Reserve policymakers out there making speeches, Lawrence, they're pretty steadfast. I mean, whether it's jawboning, whether they're actually going to do the work that they say they're going to do, it's probably a little bit of both. But you know they're pretty steadfast on their message, are they not?

Lawrence Gillum:

They are. And you know, we have heard from a bevy of these Fed presidents, Fed officials over the past few weeks, frankly, since the last meeting about their commitment to continue to raise rates until inflationary pressures come down. You know, 75 basis points is most likely going to take place at the next meeting, particularly after that stronger than expected jobs report we saw last week. So, I think, or we think that, you know, that the Fed is, is going to continue at its aggressive pace until they get to that four and a half percent range. And maybe then they take a breath and see how their rate hikes are impacting the economy. But frankly, we don't see any sort of pivot or pause in the near term just yet.

Marc Zabicki:

Yeah. And indeed, the jobs report on Friday didn't help us at all, actually, you know, as a Strategic and Tactical Asset Allocation Committee, you know, Lawrence, I mean, I will look forward to the time where our conversations are not really driven, you know, 80% of it by Federal Reserve policy and actual in inflation expectations.

 

So, that's something clearly we've been talking about as a committee, you know, throughout, you know, 2022, continue to talk about that because, you know, clearly that's driving the bus at this point in time. This week is actually going to be very interesting in terms of driving that bus. We're going to get tomorrow and then on Thursday you know, respectively, producer price index numbers out of the U.S. And also consumer price index numbers out of the U.S., You know, expecting some small recession in those numbers for the most part. And, you know, we continue to expect those numbers to actually kind of come down in fits and starts, but generally trend lower. Retail sales also expected kind of give a look into how the consumer is feeling, how their pocketbook is feeling given any Fed impacts that may have been felt since the central banks started to raise rates.

 

And then clearly, University of Michigan sentiment on Friday will help us, you know, discern that as well. That's happening out of the U.S. on the economic calendar. Turning to you, Lawrence on another thing FOMC minutes. And we clearly should have highlighted that orange because it, it certainly is going to be important in terms of the mind of the market. Any expectations from you on what we could hear or read from the Fed?

Lawrence Gillum:

Yeah, I think it's going to be a lot of the same messages that we've been hearing over the past few weeks from Fed officials, just the need to continue to raise rates until they see some sort of sustained reduction in these consumer price increases. So, I'd be surprised if the message is different in those meeting minutes than it has been, you know, over the course of the past few weeks.

 

As I mentioned earlier, we continue to get a lot of Fed speakers in the public these days. So, yeah, I would be surprised if there's anything new in there, but you never know. I mean, every once in a while there is a surprise and it does tend to move markets, and that's something, you know, we'll certainly be paying attention to.

Marc Zabicki:

Yep. Indeed. Looking outside of the U.S. what strikes me as interesting would be the U.K. unemployment rate, foreign direct investment out of China, some industrial production numbers out of the eurozone, which are always important numbers to kind of keep an eye on, CPI out of Germany and the trade balance out of China, amongst other interesting numbers, you know, for the week.

 

Again, trying to make an assessment of economic conditions outside of U.S. as well as we do in the U.S. So, keep an eye on some of those numbers this week that should drive some activity across the pond, if you will. And as you mentioned, Lawrence, I mean, you know, Lael Brainard and Charles Evans were actually speaking yesterday, and Loretta Mester is actually speaking today. And that continued drumbeat of Fed officials out there getting the message out to different folks. Interesting in Washington, D.C. where the IMF and World Banker getting together for their annual meeting, which kicked off yesterday. I haven't seen the Global Financial Stability report yet today, or the world economic outlook, but two, certainly flagship reports from the IMF that will be interesting for folks to digest, especially as it relates to the global financial stability report.

 

I'm actually very curious to see what's in there and how economic thinkers at the IMF are really, you know, digesting the monetary policy that we've seen. And then on Wednesday, FOMC minutes, as we mentioned, and Bank of Korea's policy decision as well. Any thoughts from you, Lawrence, on as dignitaries, if you will, gather in Washington, D.C. that some of the best thinkers in the world are supposed to be present? What do you think is on their mind?

Lawrence Gillum:

Yep, for sure. I did take a look quickly at the financial stability report. And it's largely as expected. You know, I think a lot of these global finance officials are concerned about the pace of rate hikes. You know, admittedly, they think the inflationary pressures are the biggest concern.

 

So, they echo a lot of the other comments that we've heard from other, you know, Fed officials and other you know, finance officials that you need to continue to hike rates, but maybe not as quickly as you have in the past. I think the big concern is the fact that what, you know, these rate hikes that happen in the U.S. or the U.K. or the eurozone, they don't stay in those regions. They are, you know, impacting global financial conditions. So, the big concern out of the IMF and the World Bank continue to be focused on these emerging market regions. So, there is concern about increased defaults, increased bankruptcies, has increased financial pressures on these emerging market countries based upon kind of these rate hikes that we're seeing here in the U.S. and the eurozone and the U.K., et cetera.

Marc Zabicki:

Yeah. I mean, it's a little bit of a dry read, but the Global Financial Stability Report is an important one. And especially now that you see a lot of the Central Bank activity and the conversations around that subject. As we mentioned, PPI and CPI this week, earnings season begins in earnest as well as some of the major money center banks here in the U.S. and other key consumer staples companies you know, deliver their earnings starting this week as we kick it off. Want, to kind of just pause for a moment again as a Strategic and Tactical Asset Allocation Committee, it's really all about inflation, all about the Federal Reserve. Not that we don't have conversations around other issues because we do but it really comes down to the trajectory of inflation and what the Federal Reserve may or may not do around inflation.

 

So, this is a pie chart simply of the CPI weights and the variables that go in and the construct of U.S. CPI. This is really interesting because we're going to show in the next couple charts that housing continues to be problematic in terms of its upward pressure on inflation, but durables, non-durables and services less housing are beginning to decelerate in terms of the month over month or year over year inflation read as we get those, you know, those new monthly figures. And, you know, so there's things that are going on under the headline CPI that are a little bit different whether it's housing versus the rest of the makeup of the CPI, you can see some of that here in this chart where, you know, non-durables looks like it's kind of rolled over.

 

Durables is clearly rolled over. The broader CPI number is in fact the, you know, the black line services less shelter still fairly strong, but we're going to actually look at a number that that indicates it may actually be on the, on the cusp of rolling over housing. Just turning to you, Lawrence, on housing, I don't know that we see, I mean, obviously mortgage rates are having an impact on housing and that's the expectation. But is there anything in terms of the way you think about it, about you know, what could come from this housing variable and how it could impact, you know, Fed Reserve policy or how capital market participants think about housing and the CPI?

Lawrence Gillum:

Yeah, for sure. And I think it is very important to kind of break out these underlying components because as you can see, they are moving in different directions except for services less shelter and housing. Housing is kind of a catchall category that's trying to capture rental prices and the increase of rental prices. So, it's kind of, it's one of those categories that, I mean, if you're a homeowner and you have a 30-year fixed mortgage, that part of the inflationary prints aren't impacting you. So, I think, you know, 65% of folks in this country have a mortgage and are homeowners. So, a big swath of folks aren't being negatively impacted by the increase in rents. So, I do wonder if the Fed is going to look through the increase in housing or the rental component there, because it isn't a broad-based category like non-durables or services less shelter.

 

And we do know that housing that tends to be a stickier component within inflationary pressures. So, we could see these elevated, you know, CPI prints, but the actual impact of these inflationary pressures aren't as high as maybe the CPI print is showing. So, I do think that they may look through that, and I think that's one of the reasons why the Fed's preferred inflationary metric is the PCE index, which doesn't have as much weight allocated towards housing.

Marc Zabicki:

Yeah, I mean, that's a real good point. And you know, maybe we could, we could play Federal Reserve central banker here just for a second and begin to look at some underlying series, data series that may inform how we think CPI is actually going to look in in the months, you know, down the road.

 

So, I just took it look at some of these price series that are really building blocks of a CPI number. So, import price index, producer price index, ISM services, business prices, same thing for manufacturing, supply chain pressure index that's put together by the Federal Reserve of New York. And what we just got done, kind of talking about CPI owner's equivalent rent, which continues to be on the high side, and we'll wonder together when that in fact is actually going to roll over. But looking at the other numbers, I mean, you see in general terms, all the other price series in the indices really peaked around March and April. And there was a definitive deceleration and price pressures in all of those. So, Lawrence, the way I think about it is, I mean, we have seen some of the deceleration and inflation in the U.S. CPI year over year number.

 

It hasn't been quite dramatic, but we know here there's going to be a lag in seeing some of the import prices and producer prices as they sift through into the consumer. But I mean, I would expect, based on what I'm seeing from some of these import prices, producer prices and ISM numbers for CPI to actually continue to decelerate because as these other price series kind of roll over, that's likely going to continue to bleed into the CPI number. So, am I off in that thinking?

Lawrence Gillum:

No, not at all. I agree with you as well. I mean, we are seeing improvements in these inflationary pressures across the board absent that issue that we just talked about with owner's equivalent rent, which does tend to be a, you know, a big category within that CPI inflationary metric.

 

So, if you do see, you know, consistent deceleration of these price increases across all these factors and all these different indexes except for that owner's equivalent rent, which we know it does tend to be stickier because, you know, rents are contracts and you know, a 12–16-month contract, so they do tend to stay stickier. But if the inflationary pressures are decelerating across all these other indexes or other prices, you know, maybe the Fed can say that, you know, they're getting the job done, that they're close to you know, getting their inflationary pressures back to that 2% target. So yeah, I think there's been broad-based improvements and, you know, certainly this color coded graph here is a great way to show that.

Marc Zabicki:

Yeah, it's certainly curious as to how central bankers would perhaps look through into the variables that drive consumer prices. And some of these variables we see here have already begun to roll over. Now they're not back to where they need to be. But the directional change that we see here may be important for central bankers to take into consideration. Certainly, if we look squarely at the Federal Reserve Bank of New York Supply Chain Pressure Index, that's clearly been a big issue on a post-COVID basis. So, while we don't have a whole lot of good news to report from a general level of CPI, and we'll get a fresh number this week, we are getting some good news from the building blocks of what could be a CPI number.

 

So, something to think about as we move forward in the months ahead where we've said as an asset allocation committee that we expect the CPI to trend lower and some of these building blocks really serve to uphold that view in terms of the way we think about it. If we move on to your wheelhouse again, Lawrence, just in general terms, from a macro perspective the Federal Reserve in terms of the work it's been doing seems to be working in terms of, you know, financial conditions, because they're certainly not, you know, what they were immediately after COVID or immediately prior to COVID. What do you think?

Lawrence Gillum:

Yeah, for sure the financial conditions indexes that we're showing here, there's quite a few of them, but one of them is the Chicago Fed National Financial Conditions Index, and then we also show the Bank of America Global Financial Stress Indexes.

 

These are the way to kind of measure the transmission mechanism of higher rate hikes into the real economy. So, some of these indexes look at, you know, stock prices, bond prices, mortgage rates, things that impact you know I would say a normal person on a day-to-day basis. The goal is to tighten financial conditions to the point where frankly, you know, consumers stop spending and businesses stop hiring and you start to see a slowdown in aggregate demand. Before you see that slowdown in aggregate demand though it does tend to show up in these tightening of financial conditions. And you know, just looking at these two indexes, we've seen a pretty significant tightening of financial conditions relative or on par, frankly, to a you know, global financial crisis or a global pandemic, right? So, we've already seen a big move tighter in financial conditions and one of the reasons why we think the Fed is closer to the end of this tightening cycle than the beginning, because we've already seen financial conditions tighten pretty significantly over the past, you know, six months. And that's certainly showing up here in the data.

Marc Zabicki:

Yeah, and I think the probabilities are material that the Fed, you know, has more work to do in terms of rate increases, but, you know, we're pointing these numbers out, these financial conditions readings as well as, you know, say import prices and producer prices, just to say that, listen, the Federal Reserve rest assured, is also looking at some of these data series or all of these data series and I'm, I'm sure they're taking those into consideration as well in terms of the amount of you know, the amount of the rate increases they may engage in over the next couple months or the duration of those rate increases. As you said, Lawrence, I think we think as a committee we think they're closer to the end certainly than the beginning.

 

And especially if we start to see a CPI rollover and the PCE rollover continue or perhaps accelerate, then maybe the Federal Reserve takes their foot off the brake just a little bit more than markets are pricing in today. So, that'll do it for this edition of Market Signals podcast it's a pleasure to be with you. Lawrence, thank you for joining me this week. Folks have a good rest of your Tuesday and a good rest of the week. Thanks for joining.

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Falling Input Costs Seem to Point to Further Deceleration in U.S. Inflation

In the latest LPL Market Signals podcast, Director of LPL Research Marc Zabicki and Fixed Income Strategist Lawrence Gillum discuss the upcoming consumer price index (CPI) report and point out the decelerating price pressures we’re already seeing in a number of the underlying CPI components. They also take a look at the tightening of financial conditions as evidence that we’re starting to see Federal Reserve (Fed) rate hikes working as intended.

Markets Will Be Focused on This Week’s CPI Report

The September CPI report will be released on Thursday and while we think the report will remain elevated, we do think the positive trend of decelerating price pressures will continue. We’ve started to see several categories within the CPI report, most notably durable and nondurable goods prices, show declining price pressures. While the shelter component within the CPI report is likely to stay elevated and “sticky”, the Fed may look through that category as rental prices do not negatively affect all consumers equally.

More Positive Signs That Inflationary Pressures May Be Falling

Along with the positive trends we’re seeing in several categories within the CPI index broadly, we’re also seeing decelerating trends in supply chain pressures, import prices, and ISM services and manufacturing prices. While we recognize the Fed still has a lot of work to do to get back to its 2% target, we are seeing positive signs that inflationary pressures are moving in the right direction.

Fed Rate Hikes Are Leading to Tighter Financial Conditions

The Fed is trying to slow aggregate demand by raising short-term interest rates and tightening financial conditions, which likely remained too accommodative for too long. However, since late last year, financial conditions have tightened meaningfully and are now at or near levels deemed restrictive. Moreover, the pace that financial conditions have tightened is on par with the global financial crisis and the COVID-19 pandemic, which is evidence that Fed rate hikes are starting to work as intended.

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This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth in the podcast may not develop as predicted and are subject to change.

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