The monthly “surprises” regarding the pace of consumer inflation in the United States may be getting less surprising. A report issued by the U.S. Bureau of Labor Statistics on April 10, 2024, showed that U.S. consumer price index (CPI), prices rose at a higher-than-expected rate in March for the third month running, with both the headline and core (excluding food and energy prices) CPI up 0.4%. The core CPI has flattened out at 3.5%+ annualized rate over the three-, six-, and 12-month trailing periods.

With no downward trend evident, that’s far too rapid a pace for the Federal Open Market Committee (FOMC), the policy-setting arm of the U.S. Federal Reserve (Fed), to cut interest rates and encourage even easier financial conditions.

Housing Brings the Heat to CPI

The March CPI report showed that “supercore” inflation–core services excluding rents–picked up sharply in the first quarter, hinting that rising wage costs are passing through into prices at an accelerated pace. While the PCE deflator¹ version of this measure won’t be rising quite as fast, it may also be turning up at a more rapid rate when the March PCE data are released later this month.

Rents remain a driver of higher-than-anticipated core inflation. The largest component, owner-equivalent rent (OER), shows no sign of trending lower in recent months as a shortage of single-family homes for sale keeps upward pressure on the rental component of that market. OER makes up a third of the core CPI, and it is very difficult for core inflation to return to the pre-pandemic pace if it continues rising almost 2% faster (on an annualized basis).

There’s a little more of a hint that rent inflation is trending lower in the much smaller tenant’s rent component of the CPI report. But it’s fair to say that housing inflation has proven much stickier than many thought it would be, as low vacancy rates and strong job growth preserve a sizable imbalance between demand and supply.

Core consumer goods prices dropped modestly in March as motor vehicle prices fell. But rising import prices suggest an inflection higher in coming months.

Policy and Investment Implications

With not a single month in over two and a half years in which the core CPI rose at a pace consistent with the Fed’s 2% inflation target–and no hint of a downtrend in recent months–the chances of a rate cut in June and two more in the second half of 2024 are fading fast. Instead, the Fed is likely to hold rates steady to avoid adding fuel to a strong economy that is generating inflation that may become entrenched at a rate too far above the 2% marker.

For investors, we believe that positioning for a steeper yield curve makes sense for two reasons. First, we think the bar for a Fed rate hike is high, and policymakers are still biased towards a cut, as indicated by projections issued at the March Fed meeting.  There are a lot of Fed speakers in the coming days so we will see if that is still the case after payrolls and inflation.

Second, we see the chance for yields on five- and 10-year U.S. Treasury notes to move higher, in what would represent a bear steepening,² as the terminal rate in the policy cycle (the rate at which the Fed stops cutting) rises in response to the prospect of inflation settling in at a higher rate.

As we noted in a podcast posted earlier this month, a late-cycle economic environment brings with it an unfavorable trade-off between growth and inflation. For investors, that suggests reducing duration exposure, collecting high-quality carry, and emphasizing stocks of high-quality companies with high secular growth and market positions that confer meaningful pricing power.