The Clearest Evidence Yet that Inflation Remains ‘Sticky’

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At 8:30 New York time on Valentine’s Day, the January consumer price index (CPI) data was released.

Headline CPI (the overall number) was up 0.5% on the month — the largest increase in three months — and 6.4% year-on-year.

Core CPI, which strips out volatile food and energy prices and is more closely followed by Federal Reserve officials, was up 0.4% on the month and 5.6% from a year earlier.

These numbers were stronger than the consensus forecast, but the real devil is in the details. Here is the gist of what we see:

• Goods inflation and services inflation are on divergent paths. Goods inflation (pricing for physical stuff) is falling fast. But services inflation (activities carried out by human workers) is going up, and the pickup from rising services inflation is starting to cancel out the gain from falling goods inflation.
• Falling goods inflation is a function of healing supply chains — but supply chains don’t have an impact on rising services inflation. As supply chains add capacity and the snarls of the pandemic get worked out, it makes sense for goods prices to fall. But supply chain gains don’t impact rising service costs (activities carried out by humans and subject to labor shortages).
• Goods inflation could easily pick up again if energy prices rise. Wall Street seems 99% convinced that the China reopening will create a resurgence in oil demand that sends the oil price back into triple digits. We are skeptical, but guess what: If they are right, a triple-digit oil price will translate into goods inflation rising again instead of falling.
• Services inflation is consistent with labor shortages in lower-wage areas of the economy. Tech companies are laying off tens of thousands of high-paid workers, in part because there was so much overhiring in tech as a result of assuming work-from-home trends (and the follow-on bump in online activity) were permanent. But tech is a drop in the bucket compared to the much larger services economy of restaurants, hotels, health-care workers, and so on, and those areas are seeing labor shortages and persistent wage pressures (translating to inflation).
• The Federal Reserve can’t do much about supply chain inflation, but it can slow or stop services inflation by dampening demand. The fact that we are moving away from supply chain problems is good news for the U.S. economy. But that doesn’t mean good news for the stock market, because the Federal Reserve still needs to beat back services inflation to get the number back down to 2%.
• As a Dallas Fed official observed, the supply chain can’t recover twice, and the first recovery won’t be enough to get inflation down to the 2% target. We have seen hopes expressed that healing supply chains alone will be enough to power an equity bull market. The only way that works is if solving the supply chain problem got inflation back down to 2%. That won’t happen. This means the Fed will have to do more even if supply chain issues completely go away. That in turn means Wall Street’s hopes of a dovish Fed are still delusional.

No Bull Case for Stocks

As we have explained before, for many decades the Federal Reserve was a friend to the stock market. That condition persisted because inflation was low and wage pressures were nonexistent — conditions that allowed the Fed to step in and be accommodative whenever the economy showed signs of slowing or stalling.

Now we are in the opposite environment: The Federal Reserve is an enemy of the stock market because inflation is high and wage pressures are significant.

In this reversed condition, the Federal Reserve is going to remain hawkish (the “higher for longer” thing) until the job is done of getting inflation down, and that simple reality will force equities into a bear market.

The pain for stocks will not be over, meanwhile, until the Fed has gotten inflation much closer to its 2% inflation target, which is still far away.

And by the way, if the U.S. actually does avoid recession — a scenario that some are touting as bullish — that is even more bearish for stocks, because in the absence of meaningful economic slowdown, the Fed will have to hike even higher (which will hammer the rate-sensitive tech and financials sectors in particular) in order to try to put a lid on services inflation.

Then, too, the lagged impact of rising interest rates hasn’t walloped corporate profits yet — but it will. This will be a factor in significant earnings deterioration in the months ahead.

Investors are trying to see these factors in a different light because, simply put, they don’t want to be halfway through a bear market. They want the bear to be over already. But it is nowhere near done, because general conditions indicate we are only in the middle of this pain.

A Colorful Situation

The chart below shows top-line contributors to core CPI broken down by color, with size showing the components’ relative contribution. Energy is orange; food is yellow; commodities (ex-food and energy) are teal; and services (ex-energy) are blue.


As the chart shows, energy inflation (the orange bars) has been in steady decline. That’s nice, but will it last? Only if oil prices stay low. If the China reopening does what Wall Street bulls say it will — and oil prices respond the way they expect — energy inflation will go up again.

Then, too, food inflation (the yellow bars) has come down. Will that last? Hopefully, but the food outlook still depends significantly on Russia-Ukraine outcomes — and Russia is reportedly amassing hundreds of thousands of new recruits for another long-slog offensive in 2023. So we’ll see.

And then notice the bottom blue bars, which represent services inflation. That’s the trouble now — and services inflation is strong. Stock market bulls who say it’s a good thing the economy is strong are ignoring the impact on services inflation — and the Fed’s determination to get inflation back to 2%.

The below graphic, via Charles Schwab, gives further insight into various inflation components. The only component where prices have been falling, versus rising more slowly, is used cars and trucks — and that is only because used car prices hit stratospheric heights during the pandemic due to chip shortages restraining new vehicle production.


Finally, check out what the U.S. Treasury two-year yield has done since Feb. 1 (the day of the “dovish” Powell press conference, where we put “dovish” in quotes because such was a gross misinterpretation).



Over the past two weeks the two-year yield has moved more than 50 basis points (half a percent). That is a big deal. It shows the bond market is adjusting to reality — the reality of “higher for longer” and a dovish Fed nowhere in sight, with a strong jobs report and strong services inflation underscoring that reality.

The bull case for stocks in large part depends on the notion that inflation will rapidly decline to 2%. But that isn’t how it works — because of sticky inflation.

The closer inflation gets to the 3% or 4% range (which is still 50% to 100% above target), the stickier it will get… and if energy prices start to rise again (as China bulls and oil bulls expect) or global grain stockpiles get depleted, the energy and food components start worsening things too.

As a final note, numerous Wall Street bulls are still anticipating interest rate cuts in the latter half of 2023 — and they are trying to make an optimistic case from that expectation.

This makes no sense at all: Even if the Federal Reserve chooses to pause at some higher level, it will hold rather than cut — the equivalent of keeping the economy in a chokehold — and refuse to back down unless the economy deteriorates suddenly and dramatically.

There are scenarios where a sudden and rapid deterioration can happen, certainly — but those scenarios are the opposite of bullish for stocks.