Update on May inflation metrics, encouraging trends

  by Scott Martindale
  CEO, Sabrient Systems LLC

This is a brief update to my June post, incorporating today’s Personal Consumption Expenditures (PCE) inflation readings for the month of May.

PCE came in at +4.07% YoY, PPI was up +6.42%, and May CPI came in at +4.17%. As illustrated by the upper chart below, this abrupt surge would be frightening if it were indicative of a structural problem in the global economy. However, we all know this is mostly event-driven due to disruptions to supply chains and the spike in oil, gas, and fertilizer prices from the Iran conflict and blockade of the Strait of Hormuz (with only 2–5 ships/day passing through the strait compared to 70 under normal conditions). As these supply chain pressures have begun to ease, crude oil has fallen from $108/bbl in mid-May to $72/bbl (WTI August futures) today.

So, when you exclude food and energy prices, Core PCE and Core CPI have managed to stay somewhat under control at +3.41% and +2.82%, respectively. Even more encouraging, looking at the lower chart showing 3-month rolling annualized averages, although headline PPI and CPI annualized trends are startlingly high, the core consumer inflation numbers are actually much lower. The annualized 3-month trends show Core PCE of +3.41%, Core CPI +2.82%, and “Trimmed Mean PCE” (new Fed chair Kevin Warsh’s preferred metric) +2.78%.  Click here to read on….

The Federal Reserve Bank of Dallas calculates Trimmed Mean PCE by “trimming out” a certain fraction of the most extreme observations at both ends of the spectrum (high and low, which can distort the total) and then computing a weighted average of the remaining components to offer a more stable and relevant perspective. It has been shown to outperform the reported Core PCE (ex-food and energy) measure as a gauge of true core inflation.

I also like to follow the real-time, blockchain-based “Truflation” metric, which is updated daily based on 30 million data points and tends to presage CPI by several months. It is much better at reflecting current housing costs than CPI or PCE. It showed +2.22% as of the end of May, and today (6/25) it has fallen to +1.90% YoY.

In addition, the New York Fed’s Global Supply Pressure Index (GSCPI) for May (z-score, or number of standard deviations from the long-run average) was +1.77, which was down slightly from its April high of +1.82, as shown in the chart below. These elevated numbers are back to 2022 levels, but still well below the December 2021 high of +4.49.

The chart illustrates how GSCPI tends to lead PPI, which in turn tends to lead CPI. Note that correlation over the past 3 years of rising GSCPI and PPI, but CPI (blue) continued to recede until recently. If the Strait of Hormuz is truly open, and hostilities with Iran (and its proxies) is coming to a close, energy prices and supply chain disruptions should continue to recede, alleviating these event-driven inflationary drivers so that GSCPI can pull back towards the zero line—and pull PPI (and by extension, CPI) back down with it.

Looking ahead to the June inflation metrics, the Cleveland Fed Inflation Nowcast model predicts CPI of +3.96%, Core CPI of +2.85%, PCE of +3.90%, and Core PCE of +3.43%, as of 6/25. And the 5-year breakeven inflation rate, which reflects the implied forward expectations of investors in 5-Year Treasury Constant Maturity Securities and 5-Year Treasury Inflation-Indexed Constant Maturity Securities, has fallen to 2.19% as of 6/25.

I have been quite clear on my view of the overriding weight of the many powerful, secular, disinflationary trends vs. short-term, event-driven, or one-time price spikes. Those trends include aging demographics, slowing global population growth, accelerating disruptive innovation like AI and automation, rising productivity, falling shelter and energy costs, global peace (as hostile nations are quickly pacified/disarmed), modest liquidity growth, a stable dollar, and the deflationary impulse on the world from a struggling China. In addition, although there might be some inflationary impacts of reshoring of manufacturing and diversification of supply chains in the short term, it is also adding redundancy and additional domestic industrial capacity, i.e., “duplicative excess capacity,” in the words of Treasury Secretary Scott Bessent (for national security purposes), which is ultimately disinflationary.

I also have discussed in the past that allowing for a slightly elevated inflation rate can help “inflate away” debt as part of a 3-pronged approach in tandem with “cutting away” debt through lower spending growth and “growing our way out of debt”—as long as growth in real (after-inflation) GDP is positive (preferably strongly positive, like +2.5% or more) and exceeds growth in deficit spending, and interest rates remain contained. Notably, the BEA third estimate for Q1 GDP was raised today to +2.1% from last estimate of +1.6%). And for Q2, the Atlanta Federal Reserve Bank’s GDPNow Model is projecting +2.5%. Later in the year, some commentators are predicting as much as 6% real GDP growth for Q3.

But a lot rides on Fed policy, and I strongly urge against rate hikes. Many small businesses, homebuilders, hopeful first-time homebuyers and lower-income/working-class families continue to struggle under the weight of elevated interest rates. So, although many FOMC members are pushing for at least one rate hike this year, I continue to believe the Fed would be better advised to cut its policy rate, ultimately to 3.0% neutral rate, which would allow a broader swath of the economy to participate and contribute to a more robust and broad-based economy, most notably housing, refinancing, consumer credit, and business borrowing, not to mention provide relief to borrowers in emerging markets suffering under a rising dollar.

The hyper-financialized global economy means that rising rates could cripple debt-addicted businesses, governments (including our own federal government), and the housing market (which is critical for a healthy consumer). Sure, mortgage rates have been much higher in the past, but home prices today are based on a lower baseline of post-GFC easing and low rates. And given recent strengthening of the dollar, some emerging market economies with dollar-denominated debt may be forced into default. In other words, today’s global financial system simply can’t handle higher US interest rates.
 

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