A closer look at CPI, sticky services inflation, and why the Fed may be powerless against insurance-driven price hikes.
KEY TAKEAWAYS
Numbers alone mislead investors–algo traders move first, then humans chase
CPI headline masks the real driver: sticky services inflation
Shelter is slowly cooling, but insurance costs are rising again
Health and auto insurance are inelastic–Fed policy has no effect
The Fed may be fighting inflation it cannot actually control
MY HOT TAKES
Headline CPI releases are theater for algos, not real investors
The Fed is targeting inflation sources it can’t realistically influence
Shelter disinflation suggests cuts could actually help more than hikes
Markets overreact because most traders don’t dig into the components
If you’re trading off the headline without analysis, you’re feeding the machine
You can quote me: “Nearly 40% of services inflation is inelastic–Fed policy is useless against it.”
Virtually real. If we have learned anything in the past several months, I hope we have learned that simply accepting a “number” at face value without scrutiny is probably not healthy for your long-term financial health. I am sure that you can point to near-term market reactions to these “numbers,” and say, the market finds them important, so I must respond in kind. Economists are expecting x, and the release is x + e… and the markets undulate. Why do you think that happens? Do you think that all those economists and analysts are mashing on buy and sell buttons? Trust me, it’s not the smart people. Markets' general reactions to misses are in many cases sparked by “algo” trading systems that read the news tape and jump in to get a quick, but small return. They are not buying or selling for the long hall. No. They are getting in for a tiny return with a large amount of capital. This effectively moves markets in the immediate wake of releases when liquidity is limited. They then rely on YOU to do the heavy lifting. Most people see the move, then follow what appears to be the momentum and accentuate the move. Do you want to know who is selling that stock (assuming you're buying) to fill your reactive order? That’s right, it’s the algo which just booked its profit, leaving you holding the bag.
Now, I am not saying that these numbers are not important, and I am certainly NOT saying that the numbers often signal longer-term moves, but I am very much saying that if they are signaling changes that warrant action, it won’t matter if you buy or sell that minute or by the end of the day, or even the following day. Why am I bringing this up today, and what am I really getting at? Well, in case you haven’t noticed, markets have been heavily influenced by bond yields and the Fed policy that influences them. That Fed policy is driven by numbers that directly and indirectly affect the health of the labor market and inflation.
Late last week and earlier this week, we established that the labor market is weak, and in fact, was far weaker than we thought it was last year. This realization has caused Wall Street to step up the odds of more rate cuts. It would be hard for the Fed to argue that the labor market is strong at this point. However, the Fed may offer up another excuse for inaction based on what we all refer to as “sticky inflation.” Sticky, because it simply won’t go back to where it was prior to the pandemic–it just keeps sticking around, like an unwanted houseguest.
For the Fed, it is all about that self-imposed 2% inflation target. The target implies that if a weighted basket of goods and services costs city folks greater than 2% more than a year ago, the Fed must act. It acts by ratcheting up and down interest rates which ultimately make it cheaper or more expensive to finance things for both consumers and businesses. This theoretically affects demand which ultimately moves prices by shifting demand curves. If high ticket items, already expensive, become even more costly to purchase because of financing costs, then consumers will surely demand less, ultimately forcing prices to recede. Lowering financing costs has the opposite effect, increasing demand. As consumers, we are all sensitive to prices at some level, so this makes sense, and it is really the driving force behind Fed policy.
But what if it is not consumer demand that is causing inflation? Go on, read that question again. What if it is the suppliers that are causing inflation? Let’s take a step back and look at the CPI, which comes out this morning. Last month, overall, monthly CPI slowed from 0.3% to 0.2%, but a slight surge in services inflation had economists worried. In fact, it is services inflation that is largely responsible for that “sticky” inflation we often refer to. Goods inflation has been relatively subdued since late 2022, even deflating in many cases. Services inflation, on the other hand, will simply not go away. Have a look at my favorite Bloomberg ECAN chart to get more insight into Core Services CPI, then keep reading.
Now, pay close attention. I strongly urge you to look closely at this chart of the components of YoY CPI Core Services Inflation. Services inflation as a whole (white line) hovered around 3% prior to the pandemic, declined rapidly through the pandemic then surged through early 2023, and then declined slowly through the Fed’s hiking cycle and even beyond the Fed’s 2024, temporary pivot to cuts. However, you will note that its decline has reversed since April of this year and is slowly climbing.
Now, push your glasses up your nose and look carefully at the bars that make up the topline number. It should be clear to you that Shelter Inflation (orange bars) makes up the bulk (some 60%). That is rent and some weird rent equivalent–let’s just call it the cost of shelter (this is the source of lots of debate, but we won’t cover it today). Shelter inflation was just above 3% prior to the pandemic and was, as of the last print at 3.7%, however you should see that it is, and remains in a declining trend, albeit in a slow one.
Looking closely at the chart, you should notice that Transportation Services (mustard bars) surged and stuck around through earlier this year when it disinflated, only to slowly increase once again. What is Transportation Services? I can tell you that 46% of inflation in that category comes from Vehicle Insurance, followed by Vehicle Maintenance which makes up another 19%.
Go back to the chart and please note Medical Care Services (purple bars). That surged during the pandemic, which makes sense, and surged again after the pandemic. The post pandemic surge may have come with the rise in demand for voluntary procedures put off during the pandemic. But you will notice that it all but disappeared through early 2024, and it has been growing since. Ok, here is where it gets tricky, so I am popping in another chart. Please check it out, we are just about done–be patient.
This Bloomberg ECAN chart shows the constituents of Medical Care Services. You can see clearly how Health Insurance Inflation (green bars) deflated in 2023 only to start inflating again in mid-2024. That deflationary period in 2023 contributed significantly to the overall deflation of healthcare services inflation (white line), Core Services, and ultimately overall CPI in 2023. That said, you should also note that Professional Services Inflation (gold bars) has only increased since prior to the pandemic and has recently tailed upward.
Ok, if you have been following me, I highlighted the importance of looking more closely into market-moving numbers. CPI, the most followed gauge of inflation, is one of those numbers. It comes out this morning and will influence the markets’ bets on Fed rate cuts and the broader markets. A big part of the “sticky” inflation we–and the Fed–talks so much about is Services Inflation. A big part of that has to do with shelter. It is a big part of the problem, but it is slowly getting better. In the past few months, services inflation has been picking up, and the Fed has noticed. If we look at what caused the resurgence, it is largely from Transportation Services and Medical Services. Specifically, Health Insurance and Vehicle Insurance. It is really important to note that tariffs have nothing to do with those. It is even more important to note that health insurance is kind-of required to… survive and thrive, while vehicle insurance is required by law. That begs my final question to you. If interest rates go higher, would you demand less health or auto insurance? If prices of insurance get higher yet, would you demand less? Possibly but not likely, as, unfortunately, there are virtually no substitutes–their demand curves are almost vertical (they are highly inelastic). Folks, in this matter, the Fed’s policy is completely ineffective at controlling demand patterns of almost 40% of services inflation. The other 60%, Shelter, continues to slow and would, in fact, opposite of Goods Inflation, likely decline if rates were lower.
The Consumer Price Index / CPI comes out this morning and it is expected to have risen slightly, month over month and year over year. Markets are likely to react and, as you might expect, all eyes will be on Services Inflation as the largest culprit of the recent surge. If you want to see potential tariff impacts, you have to watch Core Goods Inflation; it is there, but it has not been meaningful… yet. I may not have been able to change your view of the markets or even inflation, but I hope that I have caused you to want to look more closely at any number that can impact your portfolio. I will leave you with one final thought. Do you know what is the single largest contributor to healthcare insurance cost? Pharmaceutical costs. Do your homework and act with purpose.
YESTERDAY’S MARKETS
Stocks traded to a mixed close in response to a weaker-than-expected wholesale inflation release. An upbeat announcement from Oracle’s AI-related forecast sent tech stocks higher pulling the S&P and NASDAQ to fresh highs.
NEXT UP
Consumer Price Index / CPI (August) may have picked up to 0.3% month-over-month from 0.2% from the prior period.
Initial Jobless Claims (September 6th) is expected to come in at 235k, slightly lower than last week’s 237k claims.