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Takeaway: The Fed is conflating what we view as a short-lived trough in reported inflation with a sustainable bottom in structural inflation trends.

This morning we received the NOV CPI report from the BLS; the big-picture takeaways are as follows:

  • Headline CPI came in at +0.5% YoY and is now accelerating on a sequential, trending and quarterly average basis; +0.5% represents the fastest YoY rate of change since DEC ’14.
  • Core CPI (i.e. excluding food and energy) came in at +2.0% YoY and is now accelerating on a sequential, trending and quarterly average basis; +2.0% represents the fastest YoY rate of change since FEB ’13.
  • Within Core CPI, the divergence between Goods and Services Inflation remains ongoing:
    • Core Goods Inflation accelerated +10bps to -0.6% YoY in NOV, but is still decelerating on a trending and quarterly average basis.
    • Core Services Inflation also accelerated +10bps in NOV and is accelerating on a sequential, trending and quarterly average basis. The current +2.9% YoY rate of change represents the fastest rate of Core Services Inflation since NOV ’08.
  • The strength in the U.S. dollar (up +10.9% YoY on a trade-weighted basis) continues to perpetuate the considerable divergence between Goods and Services Inflation, with Import Prices contracting -9.4% YoY in NOV.
    • Absent a material rip higher in the USD over the next few months, Import Price trends should continue their trending acceleration back towards 0% over the next couple of quarters in light of the dollar’s steep base effects.

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CPI

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CORE CPI

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CORE GOODS CPI

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CORE SERVICES CPI

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - Trade Weighted U.S. Dollar Index YoY   Change

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - IMPORT PRICES

What does this all mean for the U.S. consumer? For one, the pickup in Headline CPI in conjunction with the deceleration in Average Hourly Earnings means Real Wage Growth slowed to +1.6% YoY in NOV, which represents the slowest rate of change since NOV ’14. Moreover, Real Wage growth is now decelerating on a sequential, trending and quarterly average basis.

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - REAL WAGES

Thinking about CPI trends in the context of what the U.S. consumer is forced to spend money on just to survive, the Inflation Rate of “Everyday Essentials” remains rather muted at +0.2% YoY, but is now decidedly accelerating on a sequential basis and back above its TTM average for the first time since OCT ’14. As we’ve often said, everything that matters in Macro occurs on the margin.

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CPI ESSENTIALS

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CPI ESSENTIALS PLOT

It’s worth noting that the aforementioned +0.2% YoY figure is simply the weighted average inflation rate of the following CPI indices, scaled according to their respective shares of Aggregate PCE per the 2014 BLS Consumer Expenditure Survey (weights in brackets):

  • Rent (19.6% of Aggregate PCE; 37.6% of our proprietary “Essentials” Basket) Inflation decelerated sequentially to +3.19% YoY in NOV;
  • Food (12.6% of Aggregate PCE; 24.2% of our proprietary “Essentials” Basket) Inflation decelerated sequentially to +1.27% YoY;
  • Healthcare (8% of Aggregate PCE; 15.4% of our proprietary “Essentials” Basket) Inflation accelerated sequentially to +3.08% YoY;
  • Utilities (7.3% of Aggregate PCE; 14.0% of our proprietary “Essentials” Basket) Inflation accelerated sequentially to +2.64%; and
  • Gasoline (4.6% of Aggregate PCE; 8.8% of our proprietary “Essentials” Baskets) Inflation accelerated sequentially to -24.08% YoY.

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CPI RENT

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CPI FOOD

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CPI MEDICAL SERVICES

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CPI UTILITIES

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CPI GASOLINE

Looking ahead, it’s worth stressing that the next four quarters of base effects for Real PCE growth are the toughest since the four-quarters ending in 3Q08 and the next four quarters of base effects for Headline CPI are the weakest since the four quarters ended in 4Q11. Recall that Real PCE growth decelerated sharply from +2.7% YoY in AUG ’07 to -1.2% in SEP ’08 and Headline CPI recorded a massive acceleration from +1.1% YoY in NOV ’10 to +3.9% in SEP ’11.

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - Real PCE Comps Chart

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CPI COMPS

While base effects for Real GDP recede ever-so-slightly in 1Q16 – effectively implying the domestic industrial recession may bottom here in 4Q16 absent incremental #StrongDollar #Deflation – a continuation of the trending deceleration in Real PCE growth makes its appropriate to forecast a continuation of the marginal stagflation that is #Quad3 through 1Q16 – especially in the context of our #SecularStagnation and #LateCycle themes. Moreover, a return to #Quad4 by 2Q16 is equally as likely per our model.

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - UNITED STATES

Even still, it would behoove us to point out that the lack of sequential momentum in the series implies a rather muted acceleration in Headline CPI over the intermediate term. Moreover, the tight relationship between Headline CPI and the YoY rate of change in the CRB Index (r = +0.82 since JAN ’08 and +0.93 on a trailing 3Y basis) would seem to imply the former index is unlikely to sustainably breach +1.5% before returning to persistent disinflation in 1H16.

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CRB YoY vs. CPI YoY

Viewing domestic inflation dynamics through a wider lens, we see that 5Y 5Y-Forward Breakeven Rates have fallen -38bps over the past 6M to 1.7% (-30bps shy of the Fed’s +2% target for Core PCE) despite every benchmark category of high-frequency growth and inflation indicators confirming the aforementioned #Quad3 setup. As such, we continue to signal risk of the Fed tightening monetary policy into an obvious #LateCycle Slowdown. Any investor who does not consider that scenario to be both highly and increasingly probable at this point is being willfully blind to recent developments in the high-yield credit market.

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - U.S. Economic Summary

Is the Fed conflating what we view as a short-lived trough in reported inflation with a sustainable bottom in structural inflation trends? We think so.

As such, we reiterate the factor exposure recommendations we outlined at the conclusion of our 12/9 Early Look titled, “Conviction Sells” (CLICK HERE to review). The biggest risk to our thesis isn’t whether or not we are “too bearish”, but rather if we are Bearish Enough to the extent a continuation of our G3 policy divergence theme is responsible for perpetuating incremental #Quad4 #Deflation in market price and global growth terms.

Please feel free to email us with questions, comments or concerns. Best of luck out there,

DD

Darius Dale

Director