October CPI: An Inflation Shocker Sends Stock Soaring

In what was clearly a shock to the consensus, the rate of inflation fell more than expected in October. I have been preaching for the past year that the rate of inflation would fall as fast as it rose, and this report supports that assertion. The Consumer Price Index, or CPI, was unchanged in October, which was better than the expectation for an increase of 0.1%, resulting in a year-over-year rate that declined from 3.7% to 3.2%. The temporary rebound in energy prices, which was fueled by the late-summer surge in oil, has reversed course, allowing the disinflationary trend to resume. In fact, retail gasoline prices are now down 7.2% over the past year as of the latest report from the EIA.

The more important number is the core rate, excluding food and energy, which rose 0.2% and below expectations for an increase of 0.3%, resulting in a year-over-year rate of 4.0%. The disinflationary trend remains intact, with the core CPI falling to a two-year low.

Shelter costs continue to be the most influential factor in keeping the core rate elevated, and here the news is exceptionally good. The correlation between rents and the shelter component of the CPI is well established. Shelter accounts for 70% of the increase in the core rate over the past year. Current rental rates indicate that shelter costs, which rose 6.7%, should plunge over the coming 6-9 months. If shelter inflation falls to 3% on an annualized basis during the first half of next year, it could subtract as much as 1.7% from the current core rate of the CPI. That would move us very close to the Fed’s target of 2%.

Today’s report ends the discussion of rate hikes. It should also end the discussion about rates staying higher for longer. This is why interest rates across the yield curve are plunging this morning, with the 2-year yield falling well below 5%, and stock futures are soaring. We should see rate cuts begin during the second quarter of next year, as the 2% target for inflation is within sight.

The latest consumer survey from the New York Fed showed that expectations for prices in the year ahead fell from 3.7% to 3.6%. That is another step in the right direction for Fed officials, who want to be sure that expectations remain anchored.

The stall in the disinflationary trend was due to a temporary spike in energy prices, as well as a surge in the rate of economic growth during the third quarter to 4.9%. That was largely due to consumer spending, and it will not be repeated. There is no question that growth will slow well below that rate, as tighter financial conditions gradually take their toll. The stock market has been rebounding because the consensus is now confident that the rate-hike cycle is over and rate cuts are ahead. Provided the expansion can continue, even at a rate below trend, a soft landing should deliver attractive returns for stocks and bonds in the year ahead.

The rebound over the past two weeks has awakened the retail investor, as measured by the monumental surge in optimism in last week’s survey by the American Association of Individual Investors. The percentage of bulls rose from 24.3% to 42.8% in just one week, which was the largest weekly increase since the market was emerging from the Great Financial Crisis in 2009.

It looks like the little guy was one step ahead of Wall Street this time around. The professional money management community has been extraordinarily bearish as of late, which means there is plenty of fuel left for out year-end rally.