Even Goldilocks Would Be Confused

February 16, 2023

We all know the fairy tale of the wandering girl who stumbles into the home of three bears and tastes the bowls of porridge trying to find one that is the perfect temperature. This “too hot, too cold, just right” parable has been told to countless children over the generations and has also served as the perfect analogy for many market-related dynamics in recent years.

As the latest inflation data was reported this week, all I could think was – even Goldilocks wouldn’t know how to classify this one! Too hot? Just right? Both? Bear in mind (no pun intended) – markets and investors are hoping that inflation keeps declining. Such a dynamic is thought to mean the Federal Reserve would be able to stop raising short term rates – which would benefit financial assets. These inflation readings matter – as do the interpretations of them.

Here’s how the data came in:

Inflation, as measured by the consumer price index, fell slightly to 6.4% annual increase (versus 6.5% annual in December). However, the monthly change in January was 0.5% (0.4% for core) which was up from December’s 0.1% change.

Below is a summary of the month-over-month moves

Too Hot?

Those on the “too hot” side of the argument were focused on the rebound in gas prices, the continued move higher in rents, and the stickiness of increases in services (like insurance costs and hotel rooms). After a nearly flat month in December, the “too hot” camp views any increase (even one that is 0.5%) as too high – and too far from Fed’s 2% target. Further, there is real concern that the areas with fastest increases will be the stickiest (items in the services category tend to stay higher, as opposed to goods pricing). And of course, the follow on concern is that “too hot” CPI will not give the Fed any cover when it comes to stopping rate increases.

Just Right?

Those on the “just right” side of things focused on the modest nature of the increase (and that it was in line with expectations). They also reinforced the “noise” in the month over month change caused by the reweighting of the components

Sidebar regarding reweighting process/impact: Starting in 2023, the weights of the components of CPI are updated annually (starting with the January print). There is a lag in the data used to calculate the weights (2021 spending data used to derive 2023 weights). Given the volatility in consumer spending and behavior during the pandemic, there were some meaningful changes. The largest? A 1.2% higher weight to owner-equivalent rent (shelter) versus one year ago – a category that remains elevated.

After the reweighting, shelter now makes up 43% of CPI (the largest weight ever). If you add in autos, those two items alone (housing and autos) make up 59% of CPI. This group argues that these large weights will cause CPI to stay high – until they roll over as is widely expected. Autos has come well off its peak and housing is declining very fast, although there is known lag for this to show up in CPI. As a result, the two largest drivers of CPI moving forward are highly anticipated to be disinflationary very soon. The belief of the “just right” group is that once that happens, inflation will come down and the Fed will have some flexibility.

What Would Goldilocks Think?

Who is right here? If these interpretations were bowls of porridge, which would Goldilocks pick? I would suggest she would choose to blend the two together – in a word, both. In my view, this wasn’t a great print. There were some signs that price increases are sticking and a negative (or below expectation) reading would have been more definitive. And yet, there is noise in the data from the re-weightings and there is a known lag in both the weighting calculations and the time it takes for many changes (like the decline in housing costs/rents) to show up. As is usually the case in markets (and in life), there is truth to both sides.

Where do we go from here?

Investors and markets all thrive on certainty. We want to know how long inflation will last. We want to know how high rates will go. We want to know when this will all be behind us. The latest CPI print didn’t give much clarity to any of those questions. And it’s unlikely that a single CPI print ever will. What matters is the trend. And this month, taking into account the nuances of the data, we didn’t break the trend line. Inflation is coming down. Progress is being made.

So go head, rest easy just like Goldilocks did (until the bears woke her up!). This too shall pass, it will just take time.

Onward we go,

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