What’s a replacement?

The stock and crypto markets are plowing ahead up and up and up. This is likely due to the expectation of easing regulations and tax burdens that businesses are hoping to see. This positivity is negative for bond markets and interest rates. When traders expect the economy and business to flourish, they invest in riskier equities and stocks. When they are concerned about a downturn in the economy, there is “flight to safety” that typically involves investments in less risky things, like bonds and treasuries. Right now, rates are suffering from this positivity. 

Another fear to bond and interest rate investors is the return of their archnemesis, inflation. President-elect Trump has repeatedly stated that he intends to use tariffs to bring a balance in international trade.  Tariffs are taxes on imports. These taxes would make foreign goods more expensive to Americans, but make U.S. produced goods more appealing. Tariffs are generally expected to be inflationary as they drive up the cost of goods. What is unknown is how many tariffs will actually be implemented and how the mere threat of tariffs may get trade partners to cooperate. As markets see policies implemented versus just political rhetoric, they will move more predictably. 

This week saw the release of the Consumer Price Index (CPI) and the Producer Price Index (PPI) – two important inflation reports. While the Federal Reserve’s (“Fed’s”) favorite measure of inflation, Personal Consumption Expenditures (PCE), is still to come out later this month, CPI does give us a good preview. 

If we remember basic elementary math, we remember that a yearly average is the sum of all numbers in a 12-month period divided by 12. Another way to think about this is every month we add a new reported number and lose the number from 12 months ago. These are called “replacements” in economic terms.  The monthly data from exactly a year ago is replaced by current data. If the number from a year ago was high (representing a high increase in inflation) then a moderate or low number this month would cause the average to decrease. If the change in inflation from last year was low, then even no increase in inflation would show no yearly improvement. This is exactly what we are seeing happening right now.

Looking at Core Inflation from PCE in October 2023, it was 0.133%. Then November 2023 was 0.091%, and December 2023 was 0.182%. These are all very small numbers to get replaced. But, looking further down the line, January 2024 was 0.498%. That is huge comparatively. We may not see much inflation downward progress until the January reports due to these low replacements. The good news: the Fed knows this and has acknowledged it. They are not likely to be concerned with seeing inflation moderate instead of decline.

October CPI showed a monthly increase of 0.24%, which was as expected.The yearly increase was 2.6% from 2.4%, again as expected. The Core rate which strips out volatile food and energy increased by 0.28% in October and was unchanged at 3.3% yearly. Both were as expected. This was good news for the bond and rate markets since the replacement was very low and could have shown a larger than expected increase in inflation. Shelter costs stubbornly remained flat despite rental reporting continuing to show declining rental costs across the country. Interestingly, declines in Used Cars and Motor Vehicle Insurance gave us a little relief.  

The PPI for October was much like its sister report, CPI, and came in with expectations. CPI follows the prices consumers pay while PPI follows wholesale costs before they are passed on to consumers. PPI was 2% in October and yearly was 2.4%. The Core rate increased 0.3% and annually 3.1%. Now we just wait to see what PCE shows on Nov. 27. Maybe we can get an early Thanksgiving treat of low inflation to push the Fed to continue to cut rates in December. Fingers crossed!

Fed Chairman Powell spoke this week along with several of his colleagues. They introduced the possibility that they may not cut rates at their December meeting. They are going to be very data dependent. That means they are going to watch the reports closely. Which reports? PCE on Nov. 27 and the BLS Jobs report on Dec. 6. 

Looking Ahead: 

Next week is Housing Week:

• Monday: National Assoc. of Home Builders (NAHB) Market Index
• Tuesday: October Building Starts and Permits
• Thursday: October Existing Home Sales