“…shelter costs, a third of the CPI. Think about the chicken and the egg. If if the Fed lowers rates, you wind up having lower mortgage rates. You wind up having lower CPI, right. So for me, they’re enforcing that higher CPI by not cutting rates. So if you could cut rates a third of CPI comes down, a third of CPI comes down….Used car prices. Why aren’t used car prices moving down? Interest rates. So you have mortgage rates, interest rates for used car prices. Everything that the Fed is doing is fostering higher prices”.

Almost as surprising was that no one challenged this flawed understanding except to object to the use of the transitive rule (if A = B and B = C then A = C). Even CNBC’s famous bond expert Rick Santelli joined the discussion and failed to correct these assertions. (Fortunately, he agrees that inflation is a problem for the Federal Reserve). I am guessing these assertions were not ad hoc and came from somewhere that others consider to be an authoritative source, so I feel compelled to offer a correction.

First of all, the U.S. Bureau of Labor and Statistics (BLS) started phasing out financing costs from the CPI in the early 1980s. At the time, the Fed was fighting inflation with aggressive rate hikes and the inclusion of financing costs in the CPI made it hard to explain monetary policy. Thus, the current definitions of items in the CPI exclude financing costs both implicitly and explicitly. The BLS describes the inclusions and exclusions for the CPI in “Consumer Price: Concepts” where it explains that “interest costs and finance charges are…out-of-scope”.

Financing Costs Are Not Consumption Goods

Shelter costs are not based on the price of a home or its financing. Instead, the BLS uses Owner’s Equivalent Rent (OER) which is the amount a household would have to pay to rent their home.

“Using the sample of rental units, the CPI program calculates a measure of price change for each CPI index area for the rent and OER indexes. The first step is standardizing the collected rents so that all rents are on a monthly basis. These standardized rents are called normalized rents. The normalized rents are then adjusted for any quality changes such as an additional bedroom or bathroom, changes to the type of heating and cooling equipment, and changes in extra charges such as an increase in total pet fees. The CPI program also adjusts rents for the effect of aging over time. Rents are collected for the same housing units every 6 months. Consequently, each time the CPI observes the rent of a sample unit, it is 6 months older. To account for this aging, an age-bias factor is applied to the previous rent.”

There is nothing in the definition that mentions mortgage rates. The BLS considers the mortgage as part of capital and not consumption.

“Interest costs (such as mortgage interest), property taxes, real estate fees, most maintenance, and all improvement costs are part of the cost of the capital good and are also not treated as consumption items. These non-consumption costs of owned housing are out of scope for the CPI under the cost-of-living framework that guides the index.”

Similarly then, the cost to finance a car, used or new, is also the cost of the capital good and is excluded from the CPI. Here is the core of the BLS’s explanation for measuring the inflation for new vehicles:

“The new vehicles index is estimated using a transactions dataset purchased from J.D. Power that includes observed transaction-level prices and detailed vehicle information. Each observation includes a transaction price as well as a set of 40 variables including rebate values and vehicle characteristics. Sales tax rates are applied by BLS for index calculation….

The BLS also relies on prices from J.D. Power to calculate an inflation rate for used vehicles and does not include financing costs.

Hot and Sticky Inflation

While various pundits torture the data to make specific points about the insignificance or transitory nature of today’s inflation, the core CPI is actually trending higher. The upward trend confirms the bottom telegraphed by the July Beige Book.

Source: U.S. Bureau of Economic Analysis, Personal Consumption Expenditures Excluding Food and Energy (Chain-Type Price Index) [PCEPILFE], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/PCEPILFE; U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items Less Food and Energy in U.S. City Average [CPILFESL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CPILFESL, September 11, 2025.

From my perch, I still see all systems go for hot and sticky inflation. I see only additional inflationary pressures from rate cuts. Turkey learned this lesson, and much of the Federal Reserve acknowledges (or used to acknowledge?) the inflation risks. But we are officially climbing the stairs of hopeful monetary policy…hoping that the rate cuts can heal the employment market faster than it can stoke higher inflation.

Be careful out there!

Full disclosure: no positions

The post Financing Costs Do Not Impact Calculated Inflation appeared first on Inflation Watch.

This admonition is unsurprising given Macklem’s general reluctance to declare victory over inflation. While the Bank of Canada increasingly sees the elements needed to get inflation back down to 2%, Macklem stated that “we are not there yet.” They need to see sustained and further (for “a number of months”) downward momentum in core inflation.

Cautious About the Signs of Victory Over Inflation

December’s statement on monetary policy also reflected the Bank of Canada’s wavering. The statement estimated that “data and indicators for the fourth quarter suggest the economy is no longer in excess demand. The slowdown in the economy is reducing inflationary pressures in a broadening range of goods and services prices.” These conditions should have generated a declarative victory statement. Instead, the Bank of Canada proceeded to posture staunchly against inflation: “Governing Council is still concerned about risks to the outlook for inflation and remains prepared to raise the policy rate further if needed. Governing Council wants to see further and sustained easing in core inflation, and continues to focus on the balance between demand and supply in the economy, inflation expectations, wage growth, and corporate pricing behaviour.”

Still, in the interview, Macklem acknowledged that rates are likely to start coming down in 2024. He just refused to provide a timetable.

The Soft Landing

The interviewer pointed out that the scenario Macklem portrays sounds like a “soft landing” for the economy. Macklem was careful not to use that term. Instead he pointed out that much of the adjustment in the labor market has come through a reduction in vacancies instead of a large rise in unemployment. An anticipated weakness in growth for the next 2 to 3 quarters should not generate a “deep” recession. Macklem directly claimed that “we can get inflation back to 2% without a recession.”

This year will be a transition year. By the end of the year, the economy should be in soft landing mode if all goes well.

The Canadian Dollar

The Bank of Canada released its December statement on monetary policy just as the U.S. dollar was experiencing a slight relief rally against the Canadian dollar (USD/CAD) (or the Invesco CurrencyShares Canadian Dollar Trust (FXC)). The slide resumed with the Federal Reserve’s decision on monetary policy the following week and the resulting celebration over the implicit announcement that inflation in the U.S. is dead. I had long anticipated the decline at the time with a target of testing the lower part of a trading range in place since September, 2022.

After taking profits, I am back to accumulating a short position. I expect the Bank of Canada’s on-going caution and the Bank’s refusal to get dovish to act as a tailwind for the Canadian dollar. The chart below from TradingView.com shows volatility in USD/CAD distinctly driven by key events. The Bank of Canada’s next Monetary Policy Report will come on January 24th. The Fed comes around the week after.

So, overall, I continue to favor playing the trading range in USD/CAD as an eventual trip to or toward the bottom of the range. I currently cannot foresee catalysts that will push the currency pair to stray too far away from the range. If USD/CAD escapes the range, I think the odds favor a breakdown over a breakout.

Be careful out there!

Full disclosure: short USD/CAD

The post Bank of Canada’s Macklem: The End is In Sight But Rates Are Not Returning to Pre-Pandemic Levels appeared first on Inflation Watch.

For example, back in April, 2022, Richard Corbin, a research professor at the University of Michigan who has directed the consumer sentiment surveys since 1976, issued this ominous warning in describing “inflationary psychology”:

“There is a high probability that a self-perpetuating wage-price spiral will develop in the next few years. Households have already become less resistant to paying higher prices and firms have become less resistant to offering higher wages. Prices and wages will continue to spiral upward until the cumulative erosion in inflation-adjusted incomes causes the economy to collapse in recession…

…Although consumers have increasingly expected higher inflation, they have also expected a strong job market and rising wages, especially among consumers under age 45. In the year ahead, wage gains will continue to reduce resistance to rising prices among consumers, and the ability of firms to easily raise their selling prices will continue to reduce their resistance to increasing wages. Thus, the essential ingredients of a self-perpetuating wage-price spiral are now in place: rising inflation accompanied by rising wages.”

“Inflationary Psychology Has Set In. Dislodging It Won’t Be Easy” – Richard Corbin

Note well that the University of Michigan’s U.S. consumer sentiment survey showed 1-year inflation expectations last peaked in March at 5.4%. There have been encouraging signs from the subsequent drift downward. However, hopes were dashed that these numbers could convince the Fed to pause after October’s 1-year expectation of 5.1% delivered a significant jump from September’s 4.7%. In other words, at best, expectations may be stabilizing at high levels, especially with core CPI surprising to the upside in September. Note, Corbin warned about over-extrapolating trends from wiggles in inflation numbers:

“Another critical characteristic of the earlier inflation era was frequent temporary reversals in inflation, only to be followed by new peaks. That same pattern should be expected in the months ahead.”

Surveys of Consumers, University of Michigan, University of Michigan: Inflation Expectation© [MICH], retrieved from FRED, Federal Reserve Bank of St. Louis, (Accessed on 10/16/2022, note the data are updated only through August per agreement)

For reference, the 5-year inflation expectations remain just above 2% which indicates consumers are still clinging to confidence that over the “long-term” inflation will return to the “before times”.

Federal Reserve Bank of St. Louis, 5-Year, 5-Year Forward Inflation Expectation Rate [T5YIFR], retrieved from FRED, Federal Reserve Bank of St. Louis, October 16, 2022.

Corbin wrote on the heels of the Fed’s first rate hike which was a mere 25 basis points. Corbin reacted with dismay and presciently argued:

“What was perhaps more surprising was that the quarter-point hike the Fed adopted in March was simply too small to signal an aggressive defense against rising inflation. Instead, it signaled the continuation of a strong labor market along with an inflation rate that would continue to rise.

Much more aggressive policy moves against inflation may arouse some controversy. Nonetheless, they are needed.”

Apparently, the Fed got the message and has been aggressively hiking starting with May’s rate hike!

If inflation expectations remain stubbornly elevated, then the time when the Fed is finally forced to take a pause could present a critical juncture of economic tension. In this scenario, I expect those who applaud the Fed’s pause will dismiss on-going high inflation expectations as transitory or even uninformed. Watch out if those expectations achieve new highs in the wake of a Fed pause.

The current controversy about aggressive policy demonstrates an instructive contrast with the last tightening cycle. What a difference pace can make! The S&P 500 (SPY) (red line with scale on the right) had little problem drifting higher while the Fed tightened with baby steps from 2016 to 2018. A sharp correction in late 2018 helped to convince the Fed to pause and then bring rates down. Market participants are still waiting for the Fed to care about the current market sell-off in the wake of higher rates.

Board of Governors of the Federal Reserve System (US), Federal Funds Effective Rate [FEDFUNDS], retrieved from FRED, Federal Reserve Bank of St. Louis; S&P Dow Jones Indices LLC, S&P 500 [SP500], retrieved from FRED, Federal Reserve Bank of St. Louis, October 17, 2022 (data available through September 1, 2022)

Be careful out there!

Full disclosure: short SPY put spread

The post Inflation Expectations and Inflationary Psychology appeared first on Inflation Watch.