Green Light

The S&P 500 has climbed to fresh highs in recent days, driven primarily by AI-fueled tech stocks. Other stock indexes like the Dow and Russell 2000 haven’t been quite as strong. Still, the market has enjoyed a nice bounce from April’s little 5% correction. Even bonds have been in rally mode since the beginning of May. Lower inflation expectations are giving stocks & bonds a green light.

Inflation softened a bit in May for the second straight month. The Consumer Price Index (CPI) slowed to an annual rate of 3.3% vs. 3.4% in April and 3.5% in March. The Federal Reserve’s long-run target is of course 2%, so we’re still well above what they might call normal. And that’s precisely why Mr. Powell isn’t quite ready to begin lowering interest rates.

Still, inflation is again moving in the right direction, and this report included some encouraging details. First, Core CPI, which excludes food & energy, posted its slowest rate of year-over-year growth in more than three years. The Fed (and most economists) tend to view core inflation as a better indicator of underlying price growth in the economy than the “headline” CPI. Second, prices for services like auto insurance, airfare and video streaming are at long last beginning to decline. Third, prices for goods like new cars & groceries are stalling.

The Federal Reserve wrapped up its monthly policy meeting yesterday and announced it will keep interest rates at current levels for a while. Fed Chair Jerome Powell explained that economic growth and consumer spending remain “solid.” And while the labor market is “coming into better balance,” unemployment remains historically low. These trends are not expected to deteriorate significantly this year.

Of course, that’s good news, but it’s also why the Fed isn’t budging on interest rates. After all, economic strength has propped up inflation and kept it from falling back toward the 2% target. Not surprisingly, Fed officials now expect only one .25% rate cut later this year vs. three cuts in the prior survey. And, tellingly, the Fed thinks it will take another 2 ½ years to get inflation down to 2.0%.

Why so long? One of the biggest hurdles in getting inflation down to normal is the cost of shelter. This makes up about one-third of CPI, and the way they calculate it is rather quirky. To begin, the data is intentionally lagged in order to calculate average rent of all tenants—even those who signed leases three years ago. And it includes a contrived method of tracking changes in hypothetical rent if homeowners were to lease instead of own their properties. In addition, our country’s structural shortage of housing is partly to blame for rent inflation, as are lingering distortions caused by the pandemic. Mr. Powell says it could take years for these factors to work their way through CPI data.

At present, CPI’s annualized inflation rate on shelter is 5.4%. By contrast, the Zillow Rent Index—not subject to some of the weirdery described above and focusing on the actual cost of new leases—is closer to 3.4%. And a relatively new data series from the Bureau of Labor Statistics, called the New Tenant Rent Index, has fallen to nearly 0%. The point is, we’re experiencing more progress on inflation than CPI suggests.

This is one reason why Wisdom Tree’s chief economist, Jeremy Siegel, believes the Fed will end up cutting rates twice before year-end. In an interview this morning, he predicted the next CPI reading will be low enough to convince Fed officials to move. Right on cue, we got another report that corroborates his view. The Producer Price Index (PPI) measuring wholesale inflation actually declined from April to May as prices fell for food, construction, energy and services. On a year-over-year basis, PPI is up only 2.2%.