This Week’s Developments in the US Economy

Going Up? Why the Fed Might Surprise Markets.

Despite continued economic momentum, markets are not expecting a rate hike at next week’s FOMC meeting, and many market observers align with this sentiment. We believe the Fed is prepared to continue tightening, and our review of the recent data releases underscores several areas where economic indicators remain robust—a potential Fed concern in “doing too little.” With indications that this is a live meeting, a rate hike is not out of the question in our view. Additionally, an updated Summary of Economic Projections (“SEP”) is scheduled for release next week, which will provide further insight into FOMC members’ position on policy, prices, productivity, and labor markets. If the FOMC members’ views are consistent with the previous SEP, the current trajectory of the economy would suggest that there is more work to be done as a majority of members on the previous dot plot signaled the need for an additional rate hike by the end of the year. In the absence of forward guidance from the Fed on specific economic indicators, both CPI and core CPI remain far from their respective stated targets (as does PCE), and we anticipate that base effects will show less progress in curbing inflation than desired. As such, we examine base effects, and why we shouldn’t expect either measure of inflation to approach a two percent target over the next few quarters.

The August CPI print showed that all items index increased 3.7% year-over-year compared to 3.2% in July. Similarly, core CPI rose 4.3% year-over-year. While the increase in headline CPI is mainly due to a rise in energy prices, we are also observing how the base effect is likely to keep year-over-year inflation elevated from one month to the next.

Why the recent inflation print might not be sufficient to stop the rate hike cycle

We see the potential for the Fed to think monetary policy is not restrictive enough in the context of four areas: economic productivity, labor markets, services spending, and energy prices. On productivity, the Atlanta Fed’s GDPNow, which provides a running estimate of real GDP growth based on available data, is running well above consensus at an annualized rate of 5.6% as of September 8, 2023. In a similar vein, the labor market is stronger than headline suggests—but for two isolated events including Yellow’s bankruptcy and Hollywood Actors’ Strike, the last labor print would have come in well over 200,000 net new jobs. Further, as consumer spending pattern normalizes, shifting from commodities to services, we should not expect prices in the services categories to drop as quickly as commodities as the former tends to be stickier. Additionally, we anticipate oil prices will experience additional upward pressure as key members of OPEC+ reduce production, and dwindling buffers from the US Strategic Petroleum Reserve are likely to result in additional price pressures.

Why base effects matter for gauging inflation

Inflation calculation relies on the CPI level for the current month as well as the CPI from twelve months earlier, which serves as the initial or base value. This comparison against past CPI levels is what leads to the concept known as the base effect. Given that the headline CPI annual rate reached its highest point in June 2022, the corresponding CPI rate in June 2023 might appear modest and suggest a significant drop in inflation. However, going forward the year-over-year inflation rate, calculated based on gradually slowing CPI levels from the prior year, would not indicate a continued deceleration but rather an increase from the base, hinting at a potential rise in annual inflation following consecutive months of declines.

What to watch: immediate versus lagged base effects

• Immediate Base Effects (e.g., household furnishings and other rate-sensitive areas) are CPI components that peaked at the same time as the overall CPI inflation. These will demonstrate immediate base effects, including most commodities (see accompanying table). While the immediate base effect indicates shifting consumption patterns as consumers move towards services consumption, it also indicates the immediate effects of interest rate hikes.
• Lagged Base Effects (e.g., shelter components of CPI, not to be confused with real-time apartment rent changes) are CPI components that peaked later and include mostly services. Most services components of CPI inflation peaked after September 2022, which also indicates a lack of interest sensitivity of these items (see accompanying table). For example, while the CPI peaked in June 2022, the rent of primary residence component peaked in February 2023, eight months later. This lagged effect is understood when comparing to, for example, Zillow’s rent data, which showed a peak in February 2022 (twelve months earlier).
• Similarly, it’s important point to note that we are seeing a normalization in services consumption. That is, services are not increasing beyond the historic averages but settling back into a longer-term trend. The implication is that even after a meaningful increase in service sectors in the labor force, services inflation may not come down as quickly as goods inflation, which suggests elevated inflation readings over the next several months.
  
  

This Week’s Developments in the Global Economy

Going Down? Optimism for Global Growth May Take a Step Back.

The Organization for Economic Co-operation and Development (“OECD”) releases its Global Economic Outlook twice a year, with interim assessments in between. Over the past year, we have seen optimism in the outlook for global growth by both the OECD and the IMF. However, recent developments, such as surging energy prices, elevated interest rates, and a protracted slowdown in Germany are likely to weigh on these improvements. Announced cuts in oil production by OPEC+ suggest that energy prices, a main contributor to headline inflation globally, may weigh on growth for an extended period. In a not-so virtuous cycle, this could lead many central banks to continue raising interest rates or maintain the current rates high for longer. While not yet at the level of a global economic shock, global energy pricing is a concern that should be monitored for both its direct and indirect effects.    

Why energy prices could paint central banks into a corner: the Eurozone example

At the start of April 2023, OPEC+ oil producers reached an agreement to implement a production cut, and this week key members, Saudi Arabia and Russia, announced extended production cuts through the end of the year. With a continued robust demand for oil, the announced reduction in future supply has resulted in a surge in oil prices.

As global energy prices preceded the recent increase in global inflation, another runup in energy prices seems more likely than not to have a similar outcome (see accompanying visual). For example, following Russia’s invasion of Ukraine last year, oil prices saw dramatic increases as Brent Crude Futures reached as high as $99 per barrel. As energy prices declined meaningfully through the middle of 2023, falling to a 12-month low of $71 per barrel, prices have once again started to rise, increasing by roughly 29%, surpassing $92 per barrel.

Unlike many contributors to inflation, monetary policy cannot directly affect this type of secular price pressure. However, the indirect effects on energy-sector sensitive sectors could influence many central banks to stay in a policy restrictive position with the potential for further tightening. In the Eurozone in particular, headline CPI remained unchanged in August, indicating that the battle on inflation has not yet been won. Consequently, our view is that the ECB may deem another hike is necessary to curb inflation.