Time to Worry About US Inflation?

James Knightley of ING reports that US consumer price inflation undershot expectations in September and with the growth outlook deteriorating the Fed has the flexibility to offer more “insurance” rate cuts:

US headline inflation was flat on the month versus expectations of a 0.1% month on month gain, which leaves the annual rate of inflation at 1.7%.

Meanwhile core inflation, which strips out volatile food and energy products and services, also undershot. It rose 0.1%MoM - the weakest rise for four months, leaving the annual rate of core CPI at 2.4%. This is important because there had been some concern that inflation pressures were starting to build following three consecutive 0.3%MoM increases. If the pick-up had continued it could have been perceived as a constraint on potential future Fed stimulus.

Looking at the details energy was a drag given the declines in gasoline prices, but there was also a big fall in used car prices (-1.6%MoM) and apparel prices fell 0.4% - the first decline since April. Medical care costs also showed a slower rate of inflation, but the shelter component remains firm, rising 0.3%.

Tariff hikes felt in goods prices, but pipeline price pressures look to be easing

A focus on growth

There continues to be evidence to suggest that tariff hikes are putting upward pressure on consumer prices, given the marked pick-up in goods price inflation in recent months. However, inflation is a lagging indicator and service sector inflation doesn’t show a broader threat. With PPI and wage growth slowing we may already be seeing a moderation in pipeline price pressures that results in the Fed retaining a relaxed attitude to inflation, especially given the weakness in forward-looking activity survey such as NFIB and ISM. Moreover, with real wage growth softening the outlook for consumer spending may also be a little less rosy.

Real wage growth no longer accelerating

Between now and October 30

Looking at the data flow between now and the October 30 FOMC meeting, we have to say the odds of a third rate cut from the Fed are likely to increase.

Next week’s retail sales will have positives from autos, but gasoline will be a drag and chain store sales have been softer. Industrial production will fall, led by manufacturing, given employment in the sector fell and the ISM production component is firmly in the contraction territory. Housing data may be supported by falling mortgage rates, but the declines in consumer confidence suggest this may not last.

Other than that it is durable goods orders, which is already pointing to a contraction in investment spending in Q4 and then we have 3Q GDP the day of the Fed meeting – we are forecasting 2% growth with the Atlanta Fed Nowcast currently at 1.8%. The last Fed official scheduled to speak are Charles Evans and John Williams on October 17th, but by that point, we suspect a 25bp cut will be virtually certain in the market’s mind versus the 76% (19bp) currently priced.

An astute blog reader of mine is worried about US inflation, or at least wants to be ahead of the curve if inflation pressures are building.

He sent me this: "Median CPI at 3%, six-year trend up. I’m struggling to reconcile this with the idea that deflation risk is high. How do you do it?"

I told him I'm not too concerned stating the following:

"This is a classic lagging indicator, you should draw it with the yield curve to appreciate how it lags. Above this, I’d be curious to see G7 CPI trends ex US. Did you see the PPI numbers earlier this week? Lastly, if inflation is trending up why are bond yields trending lower? The bond market knows it’s a lagging indicator."

Unsatisfied with my snappy reply, he came right back at me:

I know inflation is a lagging indicator in relation to recessions. But I wasn't asking about that.

Regarding PPI, I don't know much about it and I'm not interested in one month readings on any inflation indicator.

As for the bond market, you can't have it both ways. For over a year you argued that the bond market had it wrong, selling off and indicating rates were going higher. Now you argue it's prescient. Either it's prescient or not. It's not credible to suggest its prescient only when it agrees with you. To be sure, I think it is generally the "smart" money, and I would never ignore it. But when the buying or selling looks panicky, as it has recently, just as the selling did last summer, then I tend to discount it.

My real point is just this: if inflation has been flat or trending down, and the forces of disinflation have been overwhelming the forces of inflation, over the last six years, which appears to be the dominant narrative, how do you explain median CPI? I have no doubt it will peak and roll over at some point. My question, however, is about the trend. Will it roll over to a higher low, and thereafter roll back up to a higher high, continuing the trend over the last six years; or will it roll over and thereafter conform to the aforementioned disinflation narrative.

As you know, I have for a very long time subscribed to the disinflation argument. So it's not as if a long-time inflationista is posing this question. But I always looks for ways I might be wrong. This one indicator, a solid indicator of core inflation trends, has been running counter to my long-standing argument. It behooves me to sit up and take notice. Hence my quest to try and make sense of it.

Geez, my blog readers are tough on me! Yes, it's true, after the massive bond market rally in August where US long bond yields plunged to new multi-year lows, I came out and stated that bond market jitters are overdone.

Last week, I looked at whether US stocks are set for a major reversal and stated: "We are at an important juncture, either a trade deal will lead stocks higher and bonds lower or something is going to give over the last quarter of the year, much like it did in Q4 of last year."

What happened this week? President Trump said the US has come to a substantial phase one deal with China and markets ended the week on a very high note:

Trade deal optimism followed by today's announcement sent stocks up and long bonds down as yields rose this week.

As shown below, the S&P 500 gained 0.6% this week led by Materials (XLB), Industrials (XLI) and Technology (XLK) shares:

This is how you know the algos are hard at work, the minute a deal was announced, the typical sectors you'd expect to rise the most did.

Anyway, I want to focus less on markets this week, more on US inflation trends.

As shown below, the Cleveland Fed's median CPI has been trending up lately:

And it's not just the median CPI which has been trending up. In his Q4 investing outlook for See It Market, Willie Delwiche notes the following:

While the data on economic growth (more on that in a moment) gets the bulk of the attention, there is reason not to overlook the inflation data. The inflation picture is not totally benign. The six-month change in the trimmed-mean PCE inflation indicator has risen to its highest level in a decade. This measure (published by the Dallas Fed) is moving in the direction of the median CPI (published by the Cleveland Fed). These academically-rigorous inflation measures show more price pressure than the politically expedient core inflation measures that exclude food and energy prices. This could complicate the market’s expectation of additional easing by the Fed.

Indeed, if these "academically-rigorous inflation measures" keep trending up, it could complicate the market's expectation of additional easing by the Fed and that won't be good for risk assets like stocks and corporate bonds.

Other analysts are also worried about rising inflation. Anders Svendsen, analyst at Nordea Markets, points out that the US core CPI inflation remains at the highest in more than 10-years despite cooling momentum:

“Core CPI increased slightly less than expected in September, while remaining unchanged at 2.4% y/y. The main culprits of the weaker-than-expected momentum in core CPI was a 1.6% drop in used-car prices during September, while new vehicle costs were down 0.1% and apparel prices fell 0.4%. Headline CPI also increased slightly less than expected and headline CPI inflation is trending lower due to decreasing energy prices.”

“Core CPI has been above or at 2% since March-2018, to a large extent driven by growth in core services prices. However, over the last months core goods prices have clearly increased and now stand close to the highest level since 2012 in year-over-year terms.”

“Stronger inflationary pressure has also started to appear in Fed’s favourite inflation measure, Core PCE, which hit 1.8% y/y in August. Even if Core PCE converges towards the 2% target over the next months, we don’t expect it to have much implication for monetary policy. Fed has earlier indicated that they would like to see inflation above 2 % for a prolonged period to be in line with its symmetrical 2% target.”

“More importantly is the contraction among US manufacturers and weaker growth among US non-manufacturers. Therefore, we expect another 25bp rate cut in both October and December with risks tilted towards another cut in 2020.”

I agree, the Fed wants to overshoot its 2% inflation target for core PCE and it will cut by 25 basis points later this month and likely cut another 25 basis points in December.

But if inflation starts creeping up, we can get a real cyclical problem, especially with all those negative-yielding sovereign bonds in Europe.

Also worth remembering, while deflation is my long-term structural forecast, cyclical inflation and slowing growth can lead to stagflation.

That's why this morning I was paying attention to US import prices which unexpectedly rose by 0.2% in September after dipping 0.2% in August, but most of the increase stemmed from higher oil prices. Import-related inflation more broadly was basically nonexistent.

The most important trend for me right now is the strength of the US dollar index (DXY) which is inching toward a three year high:

Why is the greenback's strength so important? Because there's a lot of dollar-denominated debt out in emerging markets and that debt needs to be paid back.

Also worth noting, as far as US inflation, one of the channels that the US imports deflation is through the strength of the US dollar. A strong dollar puts downward pressure on import prices, the price of goods being imported to the US.

When global investors are worried, they typically buy US stocks and bonds, putting upward pressure on the US dollar. And that's why I haven't been too worried about the recent rising trend in US inflation, I don't think it can be sustained for along time and neither does the bond market.

Can this change? Yes, if the bond market smells sustained inflation, this will make the Fed's job a lot tougher, it will send a jolt in the bond market, yields will surge a lot higher, and risk assets will get clobbered.

But last month, US consumers’ inflation expectations slid to a new low as workers grew more pessimistic about their job situation, data from the New York Federal Reserve showed, supporting the case for further interest rate cuts from the Fed:

The New York Fed’s monthly survey of consumer expectations, which Fed officials look at along with other data on pricing, showed consumers’ one-year inflation outlook declined 0.2 percentage point to 2.4% last month, the lowest since the survey was launched in 2013. The three-year outlook for inflation expectations fell by 0.1 percentage point to 2.5%.  

Keep your eye more on inflation expectations than any measure of inflation because that's what the bond market gauges as the most important determinant of future inflation.

So far, it's muted and this is why long bond yields aren't well above 2%.

For all these reasons, I'm not worried about US inflation and even if it appears, it's not sustainable against a weak global economic backdrop.

Below, Steve Bannon, former White House chief strategist, joins "Squawk Box" from Athens, Greece to discuss the latest on the China trade war, the 2020 Democratic primary, the impeachment inquiry and more.

Apart from the beautiful background of the Acropolis, listen to Bannon, he raises a lot of interesting issues and he's plugged into the Trump administration and has the president's ear.

Also, CNBC's Kayla Tausche reports on a letter to President Trump from China's President Xi Jinping.

Lastly, Diane Swonk, Grant Thornton chief economist, and David Zervos, Jefferies chief market strategist, join "Squawk Alley" to discuss the market and trade uncertainty.