Good June CPI print raises bets for rate cuts

Chief Economist Eugenio J. Alemán discusses current economic conditions.

The Consumer Price Index (CPI) was much better than expected in June, printing the first deflationary month for the index since July 2022 when it was -0.01%. June’s CPI was down by 0.1%, which took the year-over-year rate to 3.0% – the lowest year-over-year rate since March of 2021 (check the indicator section of this weekly for a more comprehensive view on June’s CPI numbers).

We want to repeat what we have said in the past: “One data point doesn’t a trend make.” However, the June data, after weaker than expected readings for April and May, confirm our suspicion that inflation numbers during the first quarter of the year were a fluke. As we have also said before, an institution as important as the Federal Reserve (Fed) cannot base its policy on something that may be an outlier. Now, June’s print confirms that what happened during the first quarter of the year was just that.

This was why we were very surprised when the Fed changed its view on the path for interest rates during the June FOMC meeting. If inflation has been coming down consistently with an economy growing above potential, it meant (against many pundits arguing otherwise) that above-potential economic growth was not a threat to a disinflationary path. Thus, using “a strong economy” argument to keep interest rates higher for longer made, in layman’s terms, no sense!

Now, because we believe the economy has slowed down and is probably growing at potential or

maybe just below potential, the path for inflation will continue to improve. Our concern is that monetary policy is a very blunt instrument and the Fed risks slowing down the economy too much.

There is good news on the housing front: because the yield on the 10-year Treasury follows what markets believe and not what the Fed is saying, lower yield on the 10-year Treasurys will help bring down mortgage rates. This could improve the prospects for residential investment, which has not been looking good over the last several quarters.

Is the U.S. fiscal deficit and the debt a serious issue?

Advisors’ questions via email as well as questions from audiences during presentations often focus on whether we believe the large U.S. fiscal deficits and the accumulation of these deficits over time (e.g., the U.S. debt) is a serious problem for the country. Many times, since we do not refer to the debt during our presentations, people think we are disregarding/dismissing one of the most important issues of our generation. But we are not. In fact, we already wrote a white paper on this topic several months ago, and you can find it here.

Questions and concerns on the sustainability of our deficits and the debt seem to have resurfaced recently due to S&P’s downgrade of France’s sovereign risk ratings. Here is a bit of background on S&P’s actions regarding France: “On May 31, 2024, S&P Global ratings lowered its unsolicited long- term foreign and local currency sovereign credit ratings on France to ‘AA-’ from ‘AA’ and affirmed its unsolicited ‘A-1+’ short-term foreign and local currency sovereign credit ratings. The outlook on the long-term ratings is stable.”1 In the overview of the decision, they pointed to “France’s general government debt” increasing “to about 112% of GDP by 2027 from about 109% in 2023.”

Some questioners compare the U.S. to France, asking how it is that the US has a better sovereign credit rating than France if our debt as a % of GDP is higher than France’s? This is in part due to definitional issues, as we discussed in our white paper, but it is also – and more importantly – due to the basic differences between the French and U.S. economies and tax revenues as a percentage of GDP. In the graph below we have U.S. federal debt, total as well as held by the public and the latter one, which is the one that counts (see our white paper for an explanation), is still less than what it is for France.

Some argue that what is happening has to do with the US exceptionalism or that risk agencies treat the U.S. differently, but it has to do with the fact that France’s government tax revenue as a percentage of GDP was about 46% in 2022, the highest within the OECD countries, while government revenue as a percentage of GDP was about 28% for the US. About 18 percentage points of those are federal government tax revenues while the difference (~10 percentage points) are state/local tax revenues.

Just for comparison purposes, we use below data from the OECD for 2021 (which is the latest data available) to see the major differences between the US and France.

Thus, a potential effort to increase tax revenues as a percentage of GDP for France is much more daunting than a similar potential effort by the US. Furthermore, France’s government expenditures as a percentage of GDP were close to 57% of GDP in 2023 while in the US, government expenditures as a percentage of GDP were 23.7%. To reiterate: from the country’s expenditure side, government expenditures are more than twice as a percentage of GDP in France than in the U.S., which means that any reduction in government expenditures could have a larger effect on that country’s ability to grow compared to the U.S. Risk agencies understand that such a comparison is not apples to apples. Rather, both countries’ characteristics are very different.

Why do politicians, left and right, shy away from fixing this problem?

The simple answer is that cutting expenditures and/or raising taxes is typically seen as political suicide and no politician is truly fiscally conservative, even if many times they try to sell themselves as such. Other times, politicians think that the fiscal situation will fix itself once the economy grows, or some believe in the “fiscal fairy godmother.” To some degree this was the case early in this recovery from the pandemic recession, but as inflation has come down and the industrial and fiscal packages (IRA, CHIPS Act, Infrastructure) have been put in place, the deficit has started to grow again as a percentage of GDP.

Furthermore, government revenues have not recovered with the stronger growth in the US economy, as many were expecting. Typically, deficits increase during recessions as the government spends more while taking less in government revenues, but once recessions are over and the economy resumes growth, tax revenues start to grow again. However, during this post- COVID recovery, that has not been the case. Thus, at a time when government expenditures have continued to go up, tax revenues have not kept expanding as expected.

Economic and market conditions are subject to change.

Opinions are those of Investment Strategy and not necessarily those of Raymond James and are subject to change without notice. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur. Last performance may not be indicative of future results.

Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Statistics. Currencies investing is generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.

Consumer Sentiment is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100 in the first quarter of 1966. Each month at least 500 telephone interviews are conducted of a contiguous United States sample.

Personal Consumption Expenditures Price Index (PCE): The PCE is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The change in the PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.

The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. A value above 100 signals a boost in the consumers’ confidence towards the future economic situation, as a consequence of which they are less prone to save, and more inclined to consume. The opposite applies to values under 100.

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, CFP® (with plaque design) and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.

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GDP Price Index: A measure of inflation in the prices of goods and services produced in the United States. The gross domestic product price index includes the prices of U.S. goods and services exported to other countries. The prices that Americans pay for imports aren't part of this index.

The Conference Board Leading Economic Index: Intended to forecast future economic activity, it is calculated from the values of ten key variables.

The Conference Board Coincident Economic Index: An index published by the Conference Board that provides a broad-based measurement of current economic conditions.

The Conference Board lagging Economic Index: an index published monthly by the Conference Board, used to confirm and assess the direction of the economy's movements over recent months.

The U.S. Dollar Index is an index of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies. The Index goes up when the U.S. dollar gains "strength" when compared to other currencies.

The FHFA House Price Index (FHFA HPI®) is a comprehensive collection of public, freely available house price indexes that measure changes in single-family home values based on data from all 50 states and over 400 American cities that extend back to the mid-1970s.

Import Price Index: The import price index measure price changes in goods or services purchased from abroad by U.S. residents (imports) and sold to foreign buyers (exports). The indexes are updated once a month by the Bureau of Labor Statistics (BLS) International Price Program (IPP).

ISM New Orders Index: ISM New Order Index shows the number of new orders from customers of manufacturing firms reported by survey respondents compared to the previous month. ISM Employment Index: The ISM Manufacturing Employment Index is a component of the Manufacturing Purchasing Managers Index and reflects employment changes from industrial companies.

ISM Inventories Index: The ISM manufacturing index is a composite index that gives equal weighting to new orders, production, employment, supplier deliveries, and inventories.

ISM Production Index: The ISM manufacturing index or PMI measures the change in production levels across the U.S. economy from month to month.

ISM Services PMI Index: The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers' Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector.

Consumer Price Index (CPI) A consumer price index is a price index, the price of a weighted average market basket of consumer goods and services purchased by households. Changes in measured CPI track changes in prices over time.

Producer Price Index: A producer price index (PPI) is a price index that measures the average changes in prices received by domestic producers for their output.

Industrial production: Industrial production is a measure of output of the industrial sector of the economy. The industrial sector includes manufacturing, mining, and utilities. Although these sectors contribute only a small portion of gross domestic product, they are highly sensitive to interest rates and consumer demand.

The NAHB/Wells Fargo Housing Opportunity Index (HOI) for a given area is defined as the share of homes sold in that area that would have been affordable to a family earning the local median income, based on standard mortgage underwriting criteria.

The S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index measures the change in the value of the U.S. residential housing market by tracking the purchase prices of single-family homes.

The S&P CoreLogic Case-Shiller 20-City Composite Home Price NSA Index seeks to measures the value of residential real estate in 20 major U.S. metropolitan.

Source: FactSet, data as of 7/7/2023