It seems by now that even people without a penny in the stock market have heard that the Federal Reserve’s target rate for inflation and cutting interest rates is 2 percent. And while that objective sounds terrific, the world we live in is experiencing upward pricing pressure that makes this target elusive and seemingly unrealistic.
Within the latest Consumer Price Index (CPI) report for December, there were some components that highlight certain aspects of the economy that are experiencing ongoing higher costs associated with specific long-term underlying conditions that will not be resolved anytime soon. To the market’s credit, and to the consumer as well, some things are probably going to remain expensive indefinitely.
The total CPI was up 3.4 percent year over year, versus 3.1 percent in November, and core CPI (which excludes food and energy) was up 3.9 percent versus 4.0 percent in November. The key takeaway from this report is that inflation, while improved, has lost some of its downward momentum. Therefore, the Fed isn’t likely to be in a rush to cut interest rates—at least not based on this latest CPI reading. The higher-for-longer language can be squarely applied to shelter costs.
Breaking down the CPI report further, it is clear that the cost of shelter, be it home ownership or rental units, remains stubbornly high. Strip out the cost of putting a roof over your head and inflation is running at 1.9 percent, but the shelter component is the biggest component of the CPI and it is a large pull on household budgets due to an ongoing supply shortage of affordable housing in the most desirable cities.
According to the CPI, released Jan. 11, the shelter index increased 6.2 percent over the last year, accounting for over two-thirds of the total increase in the “all items” total, less food and energy.
Some key data from the CPI include:
• The food index was up 0.2 percent month over month and 2.7 percent year over year. • The energy index was up 0.4 percent month over month and down 2.0 percent year over year. • The used cars and trucks index rose 0.5 percent month over month and was down 1.3 percent year over year. • The shelter index was up 0.5 percent month over month and 6.2 percent year over year. • The all items index less shelter was up 1.9 percent year over year.
The factors contributing to higher-for-longer housing and rental costs are ongoing low supply, resulting from a work stoppage during the pandemic, strict zoning regulations, limiting the density and types of housing that can be built in certain areas, and the cost of construction materials, labor, and land, making it more expensive to build new homes and full-featured apartment complexes.
In the first quarter of 2021, the median home price in the United States was $369,000, according to the Federal Reserve. Eleven quarter-point rate hikes later, the median home price in December was $382,600 and up 4.4 percent year over year, showing just how tight the market is for new home inventory.
According to the current CME FedWatch Tool, there is a 46.2 percent probability of the Fed cutting the federal funds rate by a quarter-point, to 5.00–5.25 percent, at the policy-making meeting of the Federal Open Market Committee on March 20 and a 50 percent chance of a second quarter-point cut at the meeting on May 1. These numbers are well off the prior week, where the chance of a March cut was a dominating 76.9 percent before the release of the CPI report. Bond yields immediately backed up across the yield curve, and stock prices gave ground against this new reality check.
Another component of the CPI that is seeing higher ongoing costs is insurance, in all its forms—property insurance, rental insurance, motor vehicle insurance, health insurance, life insurance, disability insurance, and other types of insurance. According to the latest CPI report, the cost of insurance accounted for 3.2 percent of the CPI weight, meaning for every $100 spent by urban consumers, $3.20 went to insurance payments.
The cost of car insurance alone was up 8.4 percent in 2023, according to research firm ValuPenguin, citing higher prices for cars, more traffic accidents, more car thefts, more weather-related damage, higher costs of maintenance, repairs, and medical treatment due to accidents.
A third component to inflation that isn’t likely to come down is the cost of professional services. Rising overhead costs related to rent, utilities, transportation, and wages for many professional services companies have all been raised sharply these past two years, when inflation took off. Companies are also investing in more training and technology to deliver better value to customers. Firms are being more selective about the projects they take on with a higher focus on profits and raising prices accordingly. Unless there is a deep recession, there will likely be further cost increases for essential services.
There may be some give back in food and energy prices, as has been the case in the past three weeks. And the cost of clothes, shoes, and the cost of other finished goods like consumer electronics will fluctuate lower during supply gluts, but there is likely to be very sticky pricing for shelter, insurance, professional services, medical care education, and skills training for those entering the professional trades sector.
One can argue that going forward, again short of a broad and deep recession, inflation will likely run at an annual clip of 3–4 percent, with the Fed probably having to adjust its long-term target to 3 percent from 2 percent. And here’s the good news: The stock market seems perfectly fine with this! The yield on the 10-year Treasury note has risen from 3.78 percent to 4.20 percent in the past month, with the Dow Jones Industrial Average, the S&P 500 Index, and the Nasdaq at new highs.
This market’s transition to a place where slow but steady economic growth comes with an acceptable rate of inflation is a new development and might be the new normal for the Fed in 2024. Bullish investors are buying into this narrative, which is why, in my opinion, the market is trading better against a bond market that saw some selling pressure this past week. Bond prices got ahead of themselves and are normalizing to reflect a more probable Fed scenario and stocks are taking the least path of resistance—higher.
