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We don’t think inflation is focused on enough when reviewing where the business cycle is headed. When inflation is high, the Fed needs to raise rates which slows economic growth. The Fed was left with ample room to dovishly react to the economic slowdown late last year because inflation has been modest even though this expansion is almost the longest since the 1800s and wage growth is rising.
The Fed’s dovish policy shift was supported by the January CPI report. Headline monthly inflation was flat which matched December and was below estimates for 0.1%. Year over year CPI was 1.6% which beat estimates by 0.1%, but fell from 2% in December. As the chart below shows, this is the lowest year over year change since September 2016. This latest decline was caused by the oil price correction.
When oil prices fall, core inflation is higher than headline inflation. This volatility in headline inflation explains why the Fed uses core inflation to set policy. Monthly core CPI was 0.2% which met estimates and was the same as last month. When you round yearly core CPI up, it was 2.2% which beat estimates by 0.1% and was the same as December. However, when you don’t round the metrics, core CPI was 2.148% in January and 2.214% in December. January is almost a full tenth lower than December.
This was the lowest core inflation reading since April 2018. The 2 year stack was almost exactly the same sequentially as it was 3.98% in both months, rounded to the nearest hundredths place. The big test will be in March as last year core inflation rose 27 basis points to 2.1%. If the 2 year stack stays the same, then core inflation will likely fall below the Fed’s target, which supports the Fed’s dovish turn. Core inflation should be similar or fall since there is a global economic slowdown.
Details Of The CPI Report
Energy and gas prices were down 3.1% and 5.5% monthly and 4.8% and 10.1% yearly. Energy caused transportation costs to fall 1.3% monthly. Airfare prices fell 0.9%. Housing, medical costs, and food were only up 0.2%. Housing is the biggest component of inflation. The decline in price growth should limit core inflation for the next few reports. New vehicle prices were only up 0.2% and used prices were up 0.1%. That should help those who think it’s not a great time to buy a car. Education costs were up 0.3%. Communication and prescription drug costs were flat. Apparel prices were up 1.1%, but only 0.1% yearly.
On a year over year basis, primary rent prices were up 3.4%, medical care prices were up 2.8%, tuition/childcare was up 2.8%, and drivers’ insurance was up 3.4%. Core inflation without shelter was about 1.4%. The chart on the left shows commodities inflation has fallen below zero. It has catalyzed the inflation weakness. It is 37.3% of inflation.
On the other hand, services inflation has been range bound in the past couple years. Considering how quickly nominal wage growth has increased in that period, this is a huge victory for real wage growth.
Real Wage Growth Improves Further
The chart below shows real wage growth has accelerated the fastest since 2009.
Keep in mind, real wage growth was irrelevant for many workers in 2009 because they didn’t have a job. The growth is felt by many more workers now because the economy is near full employment. This chart looks at core inflation and core inflation ex-shelter which gives us 1.25% and 2.01% wage growth. If you look at headline inflation, which is what consumers are actually affected by, the results look even better because of the decline in oil prices.
This further acceleration in real wage growth, along with heightened job creation, and low consumer leverage, explains why economists were flummoxed by the terrible December retail sales report. Now that stocks have rebounded and the government shutdown is over, the consumer might be ready to spend again as the University of Michigan’s February consumer sentiment index increased from 91.2 to 95.5 which beat estimates for 93. The expectations index was up 6.3 to 86.2 and the current conditions index was up over 1 point to 110.
Jobless Claims Aren’t A Source Of Strength
The 4 week moving average of the jobless claims index may have bottomed in September. It’s not signaling a recession, but it’s headed in the wrong direction. It increased from 225,000 to 231,750.
The bad news is the 200,000 reading in mid-January is about to come out of the average. Unless the next report falls by 39,000, the average will increase again. Another negative aspect is claims rose by 4,000 even though claims from federal workers fell from about 5,500 to 1,000. That helpful impact didn’t translate to lower claims.
Unemployment Rate Is Trending Higher
The unemployment rate is 4% which puts it above its 12 month moving average which is a big red flag for the economy and the stock market. This might not be correct in predicting this cycle because when workers come off the sidelines, they increase the unemployment rate. Many more workers are coming off the sidelines after long periods without jobs than in previous cycles. If the labor participation rate increases, it counters the increase in the unemployment rate. We would rather see people jumping into the labor market because that’s a signal people see opportunities.
Is A 20.16% Decline Coming?
The table below shows the stock market’s performance when the 4 week jobless claims average makes a 1 year high, while the unemployment rate is above its 12 month moving average and it’s below 5%.
The first time this occurs in 3 months is used to avoid overlaps. Currently, the jobless claims are at their one year high (250 above the next highest report), the unemployment rate is below 5% (at 4%), and the unemployment rate is 0.1% above its 12 month moving average. As you can see, the results of this indicator are almost uniformly negative as the average 1 year change is -20.16%.
Conclusion
Stocks are rallying in 2019 because inflation is low which lets the Fed keep rates where they are instead of raising them 3 times this year like they forecasted a few months ago. Consumer spending should be strong in the 1st half of 2019 because real wage growth is the strongest since 2009. Jobless claims and the unemployment rate are rising which might mean the labor market is going from great to good. That would be a death knell for stock returns in the intermediate term.
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