Asset Allocation

The Inflation Battle May Not Be Over
Tim Murray, CFA®, Capital Markets Strategist Multi-Asset Division

In June 2022, the U.S. CPI reading reached a whopping 8.93%, a number that left many consumers; investors; and, most notably, the U.S. Federal Reserve very concerned. But over the subsequent 12 months, inflation went on a steady march downward, with CPI ending June of this year at 3.09%. And while the last two readings have been higher, many analysts have noted that core CPI, which excludes the volatile food and energy categories, has continued to trend lower.

As a result, concern about inflation is fading—which has led some investors to conclude that the Fed is done hiking interest rates and will soon be in cutting mode.

We are not so sure. 

CPI is typically reported on a year-over-year basis. The August report of 3.71% means that the consumer price index was 3.71% higher than it was a year ago. This helps remove seasonal effects from the number and also makes it less influenced by short-term moves that may prove temporary.

However, the short-term moves may offer more information about the current state of inflation than the year-over-year number, especially at inflection points. One effective way to examine short-term trends without putting too much weight on one individual reading is to calculate the three-month moving average of CPI, instead of the year-over-year number.

When we do this, we can see that the current inflationary trends are not quite as encouraging. In fact, between July and August, the three-month moving average rose from 1.90% to 3.98%.

The good news is that, even when viewed through this shorter-term lens, the shelter category remains on a steady downward trend. This is important because the shelter category makes up a very large portion of the CPI basket—accounting for 34% of CPI as of August 2023. We can also take comfort in the fact that the forward-looking indicators point to this trend continuing over the rest of the year.

Unfortunately, the same cannot be said for other categories, all of which could be facing upward pressure in the near to medium term. The most concerning category is energy, which has recently taken a sharp turn upward. In August, the contribution to CPI from energy ended a 12-month-long negative streak, as it spiked from -0.76% to +1.97%.

And this trend looks likely to continue. Not only have oil prices climbed sharply since July, but the global supply response to higher oil prices has been surprisingly modest, as evidenced by the decrease in rig counts over the past year. Meanwhile, oil inventories have been falling rapidly, with U.S. inventories now at low levels. In fact, when the decrease in the strategic petroleum reserve is included, U.S. oil inventory is at a level not seen since the 1980s. There are also early indications that oil productivity levels in the U.S. have peaked after increasing for more than a decade.

The steady decrease in CPI readings may be coming to an end. Going forward, we are set up for a tug of war between easing shelter prices and rising prices in other categories—particularly energy. This is likely to put pressure on the Fed to keep rates at elevated levels for longer than many investors may be expecting.

As a result, our Asset Allocation Committee has recently increased its position in real assets, which includes a large allocation to energy-related equities, while also decreasing the allocation to long-term U.S. Treasury Bonds, which could suffer if interest rates remain higher for longer.

Key Insights
  • U.S. inflation has declined from its June 2022 peak, leading some to speculate that the Fed could soon switch to a more accommodative monetary stance.
  • We believe that an upward trend in some inflation categories, such as energy, could mean higher interest rates for longer than expected.

The U.S. Consumer Price Index (CPI) has trended steadily lower since peaking at 8.93% in June 2022. Despite higher readings in July and August 2023, core CPI—which excludes the volatile food and energy categories—has continued to decline. This has led to some speculation that the Federal Reserve could soon switch from raising interest rates to cutting them.

CPI data are reported on a year-over-year basis to help limit seasonal effects and the impact of short-term events that may prove temporary. While these readings have been encouraging, shorter‑term trends that typically offer more information about the current state of inflation are concerning. The three-month CPI moving average from July to August rose from 1.90% to 3.98% (Figure 1).

Short-Term Trends Show That Progress Has Been Moderating

(Fig. 1) Contribution to CPI* by category—three-month moving average

A stacked bar chart showing the core and volatile CPI categories and their respective contribution to CPI, overlaid by a line chart showing the CPI trend from January 2020 through August 2023. The line chart shows that CPI peaked in mid-June 2022 and has been declining steadily since then, with an uptick in July and August.

January 2020 through August 2023.
Past results are not a reliable indicator of future results.
Sources: Bureau of Labor Statistics/Haver Analytics. Bloomberg Finance L.P.
*Consumer Price Index (CPI) measures the monthly change in prices paid by consumers and is a widely used measure of inflation.
A moving average is a statistic that captures the average change in a data series over time.

Oil Prices Could Remain Elevated

(Fig. 2) Active U.S. Oil and Gas Rigs

Shaded line charts showing active oil and gas rigs in the U.S. from September 2018 to September 2023. The lines show that since 2020, the number of active rigs peaked around September 2022 and have been declining since then.

September 15, 2018, through September 15, 2023.
Source: Bloomberg Finance L.P.

Notably, inflation from the shelter category, which made up 34% of the U.S. CPI basket as of August 2023, has been declining, and forward-looking indicators imply a continuing downward trend. However, other categories are facing upward pressure in the near to medium term. In particular, the energy category’s 12-month streak of negative contributions turned sharply upward in August after oil prices spiked higher.  

Energy sector fundamentals point to elevated oil prices. The global supply response to higher oil prices has been modest. Meanwhile, the number of active U.S. oil and gas rigs—a useful predictor of energy supply trends—has been decreasing. Oil inventories also have been falling rapidly, and there are early indications that productivity gains in the U.S. oil patch may have peaked after increasing for more than a decade (Figure 2).

Going forward, we believe that the tug of war between easing shelter prices and rising costs in other categories, such as energy, could pressure the Fed to keep rates higher for longer than many investors expect. As a result, our Asset Allocation Committee recently added to real assets, which include a large allocation to energy-related equities, and decreased the position in long-term U.S. Treasury bonds, which could face headwinds if interest rates remained elevated for an extended period.

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This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of October 2023 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

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Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy. Actual outcomes may differ materially from any estimates or forward-looking statements made.

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