Hot Inflation, But Stocks Soar

Stocks fell at the open today after a hotter than expected inflation report (see below). Just as abruptly, however, they turned around. Currently, the Dow is up 690 points, and the S&P is up 1.9%. The VIX fear gauge actually fell back to 31.8 from 33.6 in early trading. Gold and the dollar are both trading lower, and oil is picking up steam. The bond market, however, is selling off as interest rate expectations rise.

The Consumer Price Index—measuring retail inflation—failed to decelerate as expected last month. CPI rose .4% from the prior month, and 8.2% from a year ago. Economists’ consensus forecast called for .2% and 8.1%, respectively. “Core” CPI—excluding food & energy—actually accelerated to a 6.6% annual rate from 6.3%. The prime culprit: services, and particularly rent, which grew 6.7% and accounts for a large portion of the CPI formula. In addition, food costs were 11% higher than a year ago.

I should point out that technically, CPI peaked back in June at 9.1% and has trended steadily lower since. But I think it’s fair to say investors (and maybe the Fed) expected a faster decline. In addition, Core CPI just made another cyclical high, and this will clearly put more pressure on the Federal Reserve to continue raising interest rates. This morning’s bond trade priced-in an expected Fed-funds rate of 4.8% by next April. That’s up from about 4.5% at the beginning of this month. In short, interest rate expectations are rising.

Part of the problem is that inflation data, especially regarding housing, is badly lagged. For example, Zillow tells us that rent inflation peaked in February, but CPI’s calculation is still trending sharply upward. Wharton Professor Jeremy Siegel picks out this report’s .7% monthly gain in housing inflation, saying It’s the “most distorted” detail in CPI. He believes the figure should be -.7%. And I’ll say anecdotally that while all the major home price indexes are still accelerating, Zillow says my home’s value has fallen 8% since April.

Another problem is that CPI includes an assumed, but not experienced, inflation rate called “owner’s equivalent rent,” which essentially pretends that home owners must still pay rent. This is obviously ridiculous because most mortgages are fixed, and therefore do not inflate over time. So CPI isn’t by any means perfect. The New York Fed created its own inflation index, called UIG, presumably because of CPI quirks and limitations. Anyway, UIG peaked in June at a 6.2% annual rate and fell back to 6.0% in August. We’re waiting for the September report.

I guess my point is that all this obsession and hand-wringing over a single inflation report may not be warranted. And while all inflation reports are lagged to some extent, stock prices are not. In fact, as I’ve pointed out many times in this blog, they are forward-looking. And I mention that again because today’s market reaction is not intuitive. I think it can be explained by one of a few alternative scenarios. Maybe short-term traders decided the stock market is oversold and are looking to make money on a quick rally. Or perhaps investors with time horizons longer than a few months are sensing value now that the S&P 500 is down 27%. Alternatively, both groups may be sniffing out a Fed pause. That is, the Fed may follow through on its planned rate hikes through December, then pause and take time to evaluate the impact on the economy and inflation.