On the June Inflation Cooldown

June’s US Consumer Price Index inflation report hit Tuesday morning, and headlines’ reaction compels us to give you this friendly reminder: Inflation is a monetary phenomenon, too much money chasing too few goods and services across the entire economy. Headlines will tell you inflation is all about energy prices, semiconductors and whether the Fed hikes rates. But all three are sideshows, which stocks—relatively unbothered by inflation’s latest ups and downs—know even if headlines don’t.

The headline inflation rate brought some relief, slipping to 3.5% y/y from May’s 4.2% as gas prices fell.^[i] “Core” inflation, which excludes food and energy but has some oil-intensive components (e.g., airfares), eased from 2.9% y/y to 2.6%.^[ii] Core goods inflation slipped from 1.1% y/y in May to a negligible 0.8% and fell -0.1% m/m.^[iii]

So … gas prices down, no inflation outside of gas prices, the monster is slain, party time?

Alas, not so fast. With the war in Iran escalating again and more uncertainty over the Strait of Hormuz and potential tolls, Brent crude oil (the global benchmark) has now crept back to $85 per barrel.^[iv] This is still down bigtime from its year-to-date high of $138 on April 7, but it is up from around $70 when June ended.^[v] Pundits warn this renews the risk of oil’s inflationary effects spreading beyond fuel and utilities, seeping into all consumer prices as businesses try to offset higher costs, ignoring that we just saw this is far from assured. Adding to inflation risks, supposedly, are dastardly semiconductors, whose soaring prices drove computer software & accessories prices up 17.4% y/y.^[vi] With data center construction monopolizing chips, consumer gadgets are supposedly the canary in the coalmine for all products containing microchips, everything from your thermostat to your coffeemaker to the fan keeping your bedroom cool.

Accordingly, headlines say new Fed head Kevin Warsh can’t rest easy and declare inflation licked—a viewpoint he backed in his (boring) Congressional testimony today. Which, fine, no monthly report for any economic indicator means much. Trends matter most, and it takes time to see whether a change up or down is signal or noise.

But also, this oil and chip-focused discussion misses the point. Again, inflation is not a fossil fuel phenomenon. Nor is it a memory chip phenomenon. Unless our financial system is creating a lot of new money as these prices rise, they can’t create broad inflation. Fast-growing money supply is what pumps demand through the economy and gives companies pricing power. If money supply is slow or falling, it means businesses broadly can’t raise prices and expect to sell as many physical units. Households won’t have enough disposable income to swallow higher prices in every item on their list. They will scrimp and stretch. They will drive less and do more lifting and coasting on the highway to get an extra three days before refilling the tank. They will switch to store-brand groceries. They will forgo luxuries to cover the basics. The back-to-school shopping haul will be smaller, and parents will ensure new clothes have plenty of room to let down hems as the kiddos grow.

And what happens when people buy less of this or that to stretch a paycheck? Stores, fearing a glut of unsold merchandise, cut prices. If our in-boxes are any indication, the summer clearance sales are bigger and deeper than usual this year.

Which makes sense when you see broad US money supply growth isn’t outlandish. At 6.9% y/y in May, US M4 (the broadest measure) is up from recently slow rates and modestly above average, but it is well below growth rates in the late 1990s, which weren’t an era of hot inflation.^[vii] Money supply doesn’t become a problem until it outstrips the growing economy’s ability to absorb it. The US doesn’t have that problem right now, so businesses lack pricing power and hot inflation is unlikely.

As for the prices that are rising, these result from supply and demand for oil and computer chips. Rate hikes can’t do anything about either, last we checked. The Fed doesn’t drill for oil or build chip foundries. We guess it could yank rates to the stratosphere and kill data center investment, but we doubt society would view the corresponding deep recession as “better” than higher smartphone prices. Better, we think, to remember high commodity prices (and chips are a commodity) tend to be self-correcting by spurring more investment in production. It works for metals and works for chips, just with a long lead time.

Anyway, stocks know all of this. All. Of. It. They aren’t swinging markedly on inflation news or the war’s every twist and turn. To us, they seem to be looking 3 – 30 months ahead as normal and weighing likely corporate earnings in that time. And they seem to see plenty to like out there.