Core Inflation Remains High but Shows Signs of Easing Soon While Indicators of Business Investment Look Weak

Key Takeaways:

• The Consumer Price Index (CPI) increased 0.4 percent in April, an acceleration of three-tenths from March, according to the Bureau of Labor Statistics (BLS). Over the year, prices rose 4.9 percent. Food prices were flat for the second straight month while energy rose 0.6 percent on higher gasoline prices. Excluding food and energy, core CPI rose 0.4 percent over the month and 5.5 percent over the year. Core goods prices, which rose 0.6 percent, reversed a trend of general cooling as used car and truck prices jumped 4.4 percent. Shelter cost inflation, while still high, was cooler than earlier in the year for the second straight month as rent was up 0.6 percent and owners’ equivalent rent (OER) increased 0.5 percent.
• The Producer Price Index (PPI) increased 0.2 percent in April after a 0.4 percent decline in March, according to the BLS. Prices were up 2.3 percent compared to a year ago, the slowest annual rate since January 2021. Core PPI (less food, energy, and trade services) rose 0.2 percent over the month and 3.4 percent over the year, the slowest annual rate since March 2021.
• The National Federation of Independent Business (NFIB) Small Business Optimism Index declined 1.1 points to 89.0 in April, its lowest level since 2013. On net, 23 percent of firms are reporting lower earnings this quarter, 5 percentage points more than in March. Nineteen percent of firms plan to make capital outlays in the next three to six months, the lowest since April 2020. A net 33 percent of firms report raising average selling prices this month, a decline of 4 percentage points and the smallest net percentage in two years. Inflation was no longer reported as the single most important problem facing small businesses; instead, 24 percent of firms reported quality of labor as their largest problem.
• The Federal Reserve Board Senior Loan Officer Opinion Survey (SLOOS), for the three months ending in April, reported net tightening of residential mortgage loans, especially for non-qualifying, subprime, and jumbo mortgages. There was also a reported decline in demand for residential mortgages. Nearly half of banks reported tightening credit standards for C&I loans, roughly the same as in the first quarter while standards for commercial real estate loans tightened further in the second quarter.

Forecast Impact:

Inflation came in about in line with our expectations. The underlying details point to core inflationary pressures trending somewhere between the Fed’s target of 2 percent and the current annual rate of 5.5 percent. On one hand, core inflation was elevated in part due to a likely one-month spike in used vehicle prices; we believe this will return to a general deflationary trend soon, as wholesale prices for used cars are back on the decline. Additionally, measured shelter inflation may have finally peaked as the annual rate ticked down one-tenth to 8.1 percent in April. We expect shelter inflation to slow further throughout the year as it catches up with more timely estimates of home price and rental growth, which have both been flat to slightly declining in recent quarters. The PPI also points to lower CPI at some point, though the relationship between these two measures is not always clear. The more troubling component of the core CPI remains in the core services components where elevated prices are related to high wage pressure. Given the weak recent trend in productivity growth, current wage growth is too high to be consistent with a 2 percent inflation target. Therefore, we believe the Fed will keep the Fed Funds rate above 5 percent until there is evidence of meaningful softening in the labor market that would be consistent with slowing wage related inflationary pressures.

The general pessimism in the NFIB survey remains consistent with our forecast for a recession beginning later this year as it suggests businesses will cut back on future expansion and investment efforts. The SLOOS is also consistent with this call, showing additional tightening in bank business lending. While the banking turmoil likely contributed to this tightening, it looks more like a continuation of a trend than an abrupt shock resulting from multiple bank failures. Still, we believe tightening credit conditions, either via banking stress or additional rate hikes if banking conditions stabilize, will likely continue to weigh on business investment and ultimately contribute to a recession in the second half of 2023.

Nathaniel Drake
Economic and Strategic Research Group
May 12, 2023

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