Fade The CPI Inflation Report; Here's What Matters To The Fed, S&P 500

The CPI has serious shortcomings and doesn't matter as much to the Fed or the S&P 500 as people think.

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May 14, 2023 • 4 min read

The CPI report for January will be released at 8:30 am on Tuesday. ET is being positioned as an important data release that will determine the direction of the S&P 500 and the Fed's policy outlook. This is way overblown. Wall Street could get a nice rally, if CPI inflation is lower than expected. Or, it might feel some selling pressure, if CPI inflation is higher. The CPI report is unlikely to last more than 24 hrs.

Jerome Powell, Federal Reserve Chair, has stated that he believes the core non-housing services are the most important inflation category for Fed policy. This is a subgroup in the Commerce Department’s Personal Consumption Expenditures Price Index. The tight labor market, and the strong wage growth are closely related to inflation in these core services. The CPI report will be a key source of information for economists in determining the outlook for inflation. They won't know with certainty what the CPI report will mean for Powell's preferred inflation measure on February 24. This uncertainty is a reflection of the CPI's serious flaws.

After a 0.1% increase in December, economists predict that the consumer price index will rise by 0.5% this January. The annual rate is expected to drop from 6.5% to 6.2%. The core CPI, which excludes food and energy is expected to rise by 0.3%. This would bring the core CPI rate down to 5.5%.

Powell's focus will not affect the S&P 500. It will respond to headline inflation and core inflation regardless. CPI inflation in services less housing rental will receive some attention. Some people use that as a proxy to Powell's non-housing core services, but it's nowhere near accurate.

Investors are now conditioned to react to the CPI, because last year data surprises did indeed produce dramatic market swings both when the CPI was hot and also when it cooled down. It is now of much less use. CPI reports gas price increases a few months later. Rents are falling, but the CPI doesn't report it for more than six month. The CPI is a great tool for tracking prices of goods, but those prices are falling now and the Fed doesn't care much about them.

What's the problem then? Take a look at the category of services less rent and shelter. It includes energy services, which are not part of core expenditure. If you exclude that, then tracking inflation is only possible for 25% of household budgets. This category excludes expenditures at hotels and restaurants. The Labor Department tracks health insurance costs. However, the methodology used to track these costs can produce some odd results. The most recent 3-month annualized rate of health insurance inflation is -38%.

You can create a category similar to PCE's core non-housing services by subtracting energy services, health insurance and adding food and lodging. According to the latest data, which was revised in December, inflation in this category grew at an annualized rate of 5.7% in Q4, compared with 7.4% in October. IBD will be updating those figures on Tuesday.

Comparatively, the core PCE (non-housing) services inflation rate was 4.1% in December. This is down from 4.7% in November.

The large disparity highlights the shortcomings of CPI data. It only covers 30% household budgets. Core PCE (non-housing) services cover 50% of household expenditure.

The financial services are a big difference. They account for only 0.2% of CPI but almost 5% of PCE. This includes financial services that are provided for free. An example is the reduced or renounced interest on savings and checking accounts.

Health care is the biggest difference between PCE and CPI. PCE includes spending on health care covered by the government and employers. This is why medical services make up less than 7% CPI budgets, but health care services account for nearly 16% PCE.

The CPI will not give you the best indication of PCE health service inflation, but rather Thursday's Producer Price Index. In a note published on Friday, economists at Deutsche Bank wrote that the PPI medical service component feeds directly into PCE. The news about health care inflation could be good, they said. The scaling back of the pandemic increase in Medicare physician fees, which began on Jan. 1, could lead to milder inflation after the big PCE price increases of January the past two year.

S&P 500 rose 1.1% Monday, returning above the 4100 mark. Wall Street appeared to have shed its fear of a high CPI reading for Tuesday. The current rally may have a limited upside in the near term, regardless of how it is interpreted. The retail sales report is due out on Wednesday, and it could fuel fears that the U.S. economic recovery has re-ignited. This would require higher interest rates.

Markets are pricing in a little over 50% of the chance that Fed will increase rates by three quarter points, to a range between 5.25%-5.5%.

Between now and then, a lot more data will be released and the CPI on Tuesday will have been forgotten. Powell views the tight labor markets as the greatest risk to the inflation outlook. A third rate increase won't be necessary if the job market continues to slow and wage growth moderates. The Fed will need to see a lot of progress before it can relax its guard. Two rate hikes seem almost certain, and it's not yet clear how much slowdown is needed to prevent a third.

The S&P 500 closed Monday at a 15.7% gain over its closing low in the bear market, but it is still 13.7% lower than its closing high.

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