Equity View: What Is the Better Indicator, Headline or Core Inflation?

Summary

• Inflation may be falling, but few people seem to be paying attention to the wide gap between headline inflation and still-high core inflation.
• Historically, headline inflation mean reverts back to core inflation, implying the Fed is more likely to raise rates to around 6%.
• Even in that scenario, the real Fed Funds rate will likely remain below 2%, meaning the Fed retains a dovish bias.

Market Implications

• Barring a major shock, equities are unlikely to sell off significantly unless a recession seems likely. That will probably require the Fed to raise the real Fed Funds rate well above 2% – an unlikely development in our view.
• Inflation will keep investors on edge, but we expect equities to keep grinding higher.

Headline Inflation Races Ahead of Core Inflation

Investors and the business press have paid close attention to the drop in headline inflation in 2023 – the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) have fallen to 3.3% and 3.1%, respectively (Chart 1). The hope is that this trend continues and prompts the Fed to cut rates sooner rather than later.

Less mentioned is the yawning gap between headline inflation and core inflation (inflation ex food and energy). It now stands at a negative 1.4 and 1.0 percentage points for CPI and PCE, respectively (Chart 1). In statistical terms, headline inflation is now 1.4 standard deviations below core inflation (Chart 2). These two charts clearly show a strong mean reversion relationship between headline and core inflation – and that in most cases, headline inflation is more volatile and ultimately converges back to core inflation.

Lessons of History – It is hard to say if history repeats and headline inflation heads higher. It has been decades since inflation was a problem, and the economy has changed a lot since then. And the circumstances driving inflation now are largely tied to imbalances due to the COVID lockdowns that are gradually normalising.

Also, a key source of disinflation over the past three decades was China growth, which brought cheap labour and a flood of inexpensive goods. Those days are largely gone. The labour market also remains extraordinarily tight, which will keep pressure on wages and the labour-intensive service sector.

Fed’s Next Move

We can distil these uncertainties down to two possible scenarios. First, core inflation does fall, allowing the Fed to hold it policy rate near 5% and possibly look forward to a rate cut. Second, headline inflation rises toward core inflation, leaving the Fed little choice but to raise rates toward 6%. (A third scenario is that core and headline inflation stabilise near present levels for now, leaving the Fed in a quandary.)

In either scenario, we expect the Fed to err on the side of dovishness – meaning it will make every effort to try to corral inflation without causing the dreaded hard landing.

For the record, we expect headline inflation to rise toward core inflation, although we do not have strong conviction either way. In any case, the Fed will have difficulty returning to its 2% target.

What This Means for Equities

Conventional wisdom is that higher rates are bad for equities. The theoretical explanation is higher rates imply a higher discount rate on future earnings, hence a lower valuation. That goes a long way toward explaining the 25% selloff in the SPX in 2022 when the Fed raised its policy rate from 0.00% to 4.33% – but also makes it difficult to accept the rebound 25% rally in 2023 when Fed Funds rose another point.

The simple explanation is that markets feared a recession in 2022, then turned bullish when they realized that the Fed was actually being dovish rather than hawkish and that a recession was unlikely.

We arrive at this conclusion by looking not at the absolute level or change in rates but at Fed Funds relative to inflation (Chart 3). The year over year performance of the SPX varies widely, but one clear pattern is that the major collapses occur around recessions, and more importantly, that the real Fed Fund rate (Fed Funds – inflation) is above 2%.[1] Generally speaking, that happens when the Fed is raising rates to dampen inflation. Also, there have been times when equities and the economy withstood extended periods with the real Fed Funds well above 2%, such as during the 1980s and second half of the 1990s.

Today we are at a crossroad. Because of the wide gap between core and headline inflation, the real Fed Funds rate based on core inflation is 0.6% but has just broached 2% based on headline inflation (Chart 4).

Which is the correct inflation measure for this purpose?

If it is headline inflation and core inflation is headed lower, the Fed is likely done raising rates. Equities will continue to rally though more slowly than so far in 2023. 

If headline inflation rises toward core inflation, the Fed will raise rates again. But – and this is the key point – even if headline inflation reaches core inflation, we could still be in an environment where the real Fed Funds is below 2%.

Again, broaching the 2% barrier is just the beginning of getting serious about fighting inflation. In the past, the real Fed Funds rate has usually gone well above 2% before the economy fell into recession.

Fiscal Spending Provides Floor for Equities

We do not expect the Fed to get there any time soon. As long as the economy keeps plugging away and the labour market remains tight, equities should remain on an upward trend. Even if the economy slows under the weight of higher rates, heavy fiscal spending will provide a floor that should limit downside for equities.

[1] We use Core CPI in Chart 3, but the conclusion is the same using headline CPI and headline and core PCE.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)