This Is Why Today’s Inflation Number Is Not As Good As It Seems

Today the Bureau of Labor Statistics released the October CPI number, which came lower than expected and sparked a strong rally in the stock market. Investors seem to believe that this number shows that the Fed’s restrictive monetary policies are bringing inflation down, and convince officials to relax their restrictive policies. This interpretation is dangerous for investors, and exceedingly premature.

The year-on-year October CPI number for all urban consumers was 7.7%, below the 8% consensus, and 6.3% when food and energy are excluded, lower than the 6.6% expectation. The better-than-expected inflation numbers triggered a stock market surge and by the end of the day the S&P 500 had rallied 5.5%, the highest one-day move since April 2020. It remains to be seen whether this rally will last. The likelihood that it was caused by computerized trading rather than by a fundamental change in investor sentiment is not trivial.

It is difficult for the Fed to calibrate monetary policy so precisely that it can lower inflation without causing a recession. The market has fretted for months that the Fed has been too forceful in tightening monetary conditions. To the extent that data may show that inflation is declining, it reasons that the Fed will loosen its grip and spare the economy from too much pain.

But soon after the number was released, Cleveland Fed chief Loretta Mester stated that the number was welcome news but it didn’t really change her views one bit. “I currently view the larger risks as coming from tightening too little” is what she said, echoing San Francisco Fed chief Mary Daly: “One month does not a victory make.” Daly added that the focus is to “bring inflation reliably back to 2%… I don’t see anything in the incoming information that has changed the look of that path.”

Is the Fed being too obstinate? Not really, given how they look at inflation.

While the two headline numbers are better than expected, they both benefited by the sharp decline in goods inflation, courtesy of improved supply chains. Monthly inflation in non-durable goods, for example, was negative in 3 out of the last 4 months and the durable goods inflation for October was the second-most negative since 2009.

Cheaper stuff is, of course, a good thing, but most personal expenditures are on services, and services inflation remains very high. In fact, annualized 3- and 6-month services inflation, with and without energy services (which account for 61% and 58% of total CPI, respectively), has been essentially unchanged and sky-high since May.

Inflation dynamics are complex, but most economists agree that once inflation expectations are entrenched, combating it becomes very difficult, and services inflation play a central role in those expectations. One reason is the effect of the wage-price spiral: Persistently higher prices lead workers to demand higher wages, which in turn raises price for suppliers of goods and services, leading to further wage increases.

Another, more complex effect, is the disruption of relative pricing. After a long period of low inflation, relative prices reach a stable balance – the cost of one service with respect to another is more or less predictable.

But a price shock in one input upsets those relationships, at least temporarily. A shock that is small or short-lived won’t travel far into the system and general inflation will remain in check. But a large, sudden and permanent change in the price of one input can trigger an overall price escalation, simply because those who provide the items that have not gone up have lost purchasing power relative to the rest.

This process is called “relative pricing inflation” and remains a hotly debated issue. Some economists doubt that this is a factor at all in the level of general inflation, while others think that the fight to restore relative prices to those prevalent before the shock lead to the expectation that general inflation will continue to rise. The U.S. economy has certainly seen a large change in relative pricing since the pandemic and a large increase in general inflation, so perhaps the disruption of relative pricing is more important than doubters maintain. If so, the Fed is correct at fearing the entrenchment of inflationary expectations.

Either way, there is no doubt that Fed officials believe that they “have to be resolute to bring inflation down” and are “united in that commitment,” as President Daly stated shortly after the October CPI number. It is of course possible that the Fed could eventually come to see the October release as the first glimmer of success, but the stock market rally seems way too assertive for a non-decisive one-month data point. Inflation will eventually come down, but the risk of a recession as a result of Fed policy is still very elevated, and it is doubtful that stock prices have fully incorporated that risk, especially after today’s move. Investors should continue to tread lightly.