A close look at Inflation and interest rates

Headline inflation numbers are a bit higher than the Fed's target, but that's entirely due to the way shelter costs are estimated. On balance, it's clear that the Fed has brought inflation back down to acceptable levels. 

Relative to ex-shelter inflation, interest rates remain quite high, especially mortgage rates. The Fed has plenty of latitude to lower short-term interest rates, and I expect another cut in November.

Chart #1

Chart #1 looks at the headline measure of the CPI as well as the ex-energy version, both measured over a rolling 6-mo. annualized basis. Note how much less volatile inflation is when you subtract energy prices. These two measures currently are straddling the Fed's 2% target. Notably, the total (headline) CPI is up at only a 1.6% annualized rate in the past six months.

Chart #2

Chart #2 compares the total CPI to the CPI less shelter version, both on a 6-mo. annualized basis. Here we see that both measures currently are below the Fed's 2% target. Notably, the ex-shelter version is only up at a 0.1% annualized rate! If it weren't for the BLS's faulty measurement of shelter costs, which greatly overstates housing inflation, inflation would be essentially ZERO. 

As I've noted many times in the past year or so, shelter cost inflation has been high and declining slowly (more slowly than I expected). It should continue to decline over the next several months, and that will cause the current gap between total inflation and ex-shelter inflation to narrow.

Chart #3

Chart #3 compares the same two measures as Chart #2, but on a year over year basis. The ex-shelter version of the CPI has been less than 2% in 14 out of the past 17 months, and it currently stands at a mere 1.1%. 

Chart #4

Chart #4 compares the 5-yr Treasury yield to the year over year change in ex-energy inflation. I like to use this version of inflation, because as noted in #1 above, energy is far more volatile than any other component of the CPI. Here we see that interest rates tend to move with inflation, but with a noticeable lag. And with ex-shelter inflation now at 1.1% (note the blue asterisk at the bottom right-hand corner of the chart), there is plenty of room for Treasury yields to decline.

Chart #5

Chart #5 shows the level of real and nominal 5-yr Treasury yields, plus the difference between the two, which is the market's implied inflation forecast for the next 5 years. Inflation expectations currently are about 2.2%, which should please the Fed. Here again we see that there is plenty of room for interest rates to move lower.

As an aside, I note that swap and credit spreads are trading at relatively low levels, which is a sign of abundant liquidity conditions and a healthy outlook for corporate profits. Economic conditions in general are healthy, but I continue to worry about the housing and property markets, which are burdened by very high interest rates and high prices. 

Chart #6

Chart #7 shows the level of 30-yr fixed mortgage rates and the 10-yr Treasury yield, plus the spread between the two. Mortgage spreads currently are quite wide (about 225 bps), compared to where they trade in normal conditions (about 150 bps). This wider-than-normal spread is largely driven by investor's reluctance to buy mortgages when the risk of refinancings is high. People realize that interest rates are high relative to inflation, and they understand also that lower interest rates would spark a wave of refinancings of mortgages that have closed in the past two years. In other words, the perceived downside risk of mortgage bonds is uncomfortably high, and that is depressing the prices of mortgage bonds. If anything this means that while lower mortgage rates are likely in the offing, rates are likely to come down slowly. That will keep downward pressure on housing prices in the interim.