Inflation Is Below Expectations, Flummoxing The Fed

The all-important CPI was released this week. It showed more of the same disinflationary trend we have been seeing in the past six months. I have been looking for an uptick in inflation heading into the back half of the year because of the base effect comparisons oil has since oil fell at this time last year and because of the wage inflation which could push overall inflation up. According to the July report, the CPI increased 0.1% month over month. This was below the 0.2% increase expected. On a year over year basis, inflation was up 1.7% which was a one tenth increase from June, but was below the expectation for 1.8% growth.

Looking at core CPI, it was up 0.1% for the fourth straight month and was up 1.7% year over year for the third straight month. Gas prices were flat and food prices were up 0.2%. Rental housing was up 0.2%. The owners’ equivalent to rent was up 0.3%. The cost of new motor vehicles was down 0.5% for the sixth straight decline. I have been expecting weakness in the auto sector this year. The bears were correct to point out the weakness in this sector, but they were wrong in claiming it would cause a recession as there’s very little chance of a recession starting this year. None of the major economic indicators signal we are in a recession. There are some bears who can manipulate stats to show the economy is heading off a cliff, but those prognosticators have been wrong for years.

The chart below does a great job of breaking down the situation we find ourselves in. On the one hand, you have a Federal Reserve which is being cautious with rate hikes even though the recovery has been going for eight years. Rates have been the lowest for the longest time ever. On the other hand, for the first time ever we have the Fed raising rates as inflation is falling. Usually the Fed hikes rates too high because it accelerates above inflation. In this case, only a few more rate hikes would push the Fed to a tight policy because of the drop in inflation. In theory, two more rate hikes could cause the policy to be tight if inflation falls slightly. That would lead to the Fed potentially causing a recession because of poor forecasts. From the Fed’s perspective, it thinks inflation could rise rapidly as there is a tight labor market. It thinks if it doesn’t raise rates now, inflation could get out of hand.

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