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Posted by Ragheb Othmani on Nov 10th, 2022

CPI Deep Dive: Inflation Outlook and Indicators

Every Sunday, I wake up early, jump into my car, and rush over – staying under the speed limits, of course – to buy bargains from my favourite chicken shop in the Toronto suburbs. In early 2020, I was able to buy the five KG package of chicken breast for CAD 35 at discount, or pay a little more at full price. Last week, I bought the same package from the same shop and paid CAD 57.25. Of course, there are no discount times anymore.

Inflation is everywhere from the meat shop to the hotel room. And it's not just a North American problem; it is a global phenomenon. In this article, I cover inflation’s effect on government policies, bond, and equity markets; break down the major categories that make up CPI in the U.S.; and share key indicators investors should watch for as metrics as to whether inflation is improving.

Important Highlights

  • It has been a year of decades-high inflation, but three of the four major categories of the U.S. Consumer Price Index (CPI) have started to go down, signalling potential relief ahead.
  • “Services” remains the only inflation indicator that hasn’t cooled. “Shelter” (aka rent) makes up a large portion of it, meaning that rental rates will heavily influential inflation going forward.
  • “Commodities less food and energy” is cooling off, mainly because “used cars and trucks” have been showing steep declines in YoY change since the beginning of the year.
  • The increase in food prices had been accelerating since the onset of the pandemic until last September when YoY food inflation changed direction, led by “food at home.” Conversely, the change in “food away from home” is still accelerating, mainly because of the associated services that is still pushing prices up.
  • “Energy” has been hugely volatile in 2022, and it still has the highest increase YoY among the four main CPI categories. However, energy indicators have been cooling since mid summer, as gasoline prices are coming off highs.

How inflation is influencing our economy

This inflationary environment has been shaping new aggressive Federal Reserve (FED) policies, which include the reduction of the FED’s balance sheet and raising interest rates at speeds we haven’t seen in decades.

The FED’s mandate to fight inflation has taken a huge toll on asset valuations and liquidity. Similarly, corporations are starting to feel the pain in their bottom line with higher funding costs, an increase in operating expenses, and a decline in demand. On the other hand, at least the strong employment landscape is providing a backstop to consumer health, preventing material deterioration.

The good news now is that the annual change in three of the four major categories of the U.S. CPI have started to go down. And the market hopes now that the most recent inflation trend may push the FED to reconsider its aggressive strategy.

Okay, great! Right? Well, before we begin, let’s define exactly what CPI is—besides being this mysterious metric that seems to hold so much weight over our lives and chicken cost.

CPI: its effects and its indicators

CPI is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

To measure CPI, there’s the CPI-U index, which is made of four major categories:

  1. Services less energy services,
  2. Commodities less food and energy,
  3. Food, and
  4. Energy.

Take a look at the table below to see U.S. CPI numbers for October in these categories.

U.S. CPI major categories as at Oct 2022

Source: U.S. Bureau of Labor Statistics, Oct 2022.

Analyzing CPI indicators

1. Services less energy services

As mentioned, as of October 2022, in the U.S., only one of the three major CPI categories was still increasing (i.e., not improving). Which one is that you ask?

“Services less energy services,” which is dominated by rental rates and other service-related items, remains to be the only major CPI category with accelerating YoY change as of October 2022.

Unfortunately, it is also the largest category of the inflation index, with “shelter” representing most of its components, alongside medical care and transportation services. The shelter index can be broken down further into “rent of primary residence” and “owners' equivalent rent of residences” (among other smaller subcategories), which together make up 32.6% of total CPI.

Now if we look at the table above, we can see that “services less energy services” has the most effect on CPI YoY change. This is despite that the annual change of this category was lower than CPI's, but the category has the largest weight in the basket. And it is the only major category with accelerating YoY change.

YOY percentage change of U.S. CPI
YoY change in CPI's services indicator
U.S. services inflation table as at Oct 2022

Source: U.S. Bureau of Labor Statistics, Oct 2022.

Key Takeaway: Since shelter comprises such a large portion of CPI, it means that rental rates could be one of the most influential factors in defining the direction of inflation going forward. And on that end, news about the residential renting market cooling down in the U.S. has offered some relief to investors.

2. Commodities less food and energy

Commodities US CPI table

Source: U.S. Bureau of Labor Statistics, Oct 2022.

The next CPI category we’re going to look at is commodities, which represents 21.2% of the total U.S. CPI. Commodities comprises things like new vehicles, used cars and trucks, apparel, medical care, alcohol, and tobacco.

New vehicles have had the highest increase and largest effect on this index in the last 12 months. Used car prices also still have noticeable effect; however, YoY change started to slow down sharply in 2022 after the huge jump in 2021.

YoY change in US commodities as at Oct 2022

Key Takeaway: Commodities less food and energy are cooling off, which could be an indicator of ease along the supply chain and more measured demand from consumers.

3. Food

The third major category comprising the U.S. CPI is food, which represents 13.7% of the total CPI. What’s “food” include? Well, mainly, takeout and groceries. So, what is there to say about inflation and food, besides the fact that chicken is far too expensive?

In general, the food index has been relatively volatile and has been creeping above inflation for few months now. And as you’ll notice in the chart below, food at home increased at faster rate than food away from home. I guess that means we have an excuse to eat out more nowadays.

YoY food inflation index as at Oct 2022
U.S. food inflation table as at Oct 2022

Key Takeaway: Likely the most disturbing trend of a high inflation environment – if we are finding food expensive in the developed world, how does this look in developing countries? What does this do to domestic and geopolitics? Only time will tell, but it may not be a rosy story.

4. Energy

The last major CPI category has also been the most volatile one – energy. Energy commodities and energy services are main subsectors of this index. Both have almost the same rate of change YoY.

Energy CPI index as at Oct 2022

Source: U.S. Bureau of Labor Statistics, Oct 2022.

As indicated in the chart below, its annual percentage change is the highest as of the last CPI report. However, energy’s effect on CPI has not been as significant because it has the lowest weighting among CPI major categories.

Recently, energy’s annual change has been sharply cooling off, as gasoline prices have dropped since mid summer. And together with the food index, energy’s outperformance causes core CPI to increase at a slower rate than total CPI. For example, while October’s total CPI annual change came at 7.7%, core CPI was only at 6.3%.

YoY energy CPI change for the US

Key Takeaways: Gasoline, the most weighted item in “energy commodities,” has witnessed price declines since mid summer. Meanwhile, electricity, the major component of “energy services,” has seen prices increase steadily until the most recent data when it changed course.

The Bottom Line

Inflation is sticky, no doubt about this, but recent trends in CPI categories offer hope that we've already passed peak inflation. Services including shelter are very important to watch in the coming months, because unlike commodities, services are affected by items that are rarely ticked down in the past such as renting rates and wages.

—Ragheb Othmani is an Investment Analyst at Purpose Investments

Sources: Charts and statistics are sourced to Bloomberg L. P. and the U.S. Bureau of Labor Statistics unless otherwise noted.

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Ragheb Othmani, CFA

Ragheb has extensive experience in asset management, investment analysis, clients’ communication and products development and works within the portfolio management team to identify opportunities in debt and equities.

Besides covering banks and financials in Canada and the US, he works with the team on other sectors such as REITs and mortgages REITs, retail, hospitality and others.