“…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.

Source: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items in U.S. City Average [CPIAUCSL], retrieved from FRED, Federal Reserve Bank of St. Louis, July 11, 2024

The chart above shows that the CPI stayed within a tight range of change between 0% and 0.5% until June’s reading. That pleasurable drop into negative territory for the first time since May, 2020 was enough to cause major shifts in financial markets. Investors quickly rotated out of growth stocks like big cap tech and bought up interest rate sensitive stocks and the “cheap” stuff that has been left for dead.

The iShares Russell 2000 ETF (IWM) soared 3.6% to a 28-month high, a long overdue and bullish breakout.

The iShares U.S. Home Construction ETF (ITB) surged 6.2%, quickly defied a recent downgrade from Citigroup that seemed poised to send ITB into an eventual bear market, and shook off the blues from a busted spring home selling season.

The iShares U.S. Real Estate ETF (IYR) gapped up 2.8% and almost finished recovering its losses for the year.

Even the regional banks came alive. The SPDR S&P Regional Banking ETF (KRE) jumped 4.2% and almost got back to flat for the year.

The end result of these strong gains and reversals was an abrupt improvement in market breadth. My favorite technical indicator, the percentage of stocks trading above their 50-day moving averages (DMAs), or what I call AT50 for short, climbed an astonishing 13 percentage points. A subtle downtrend came to an abrupt and definitive end.

This shift continues a string of notable divergences in market breadth. This divergence is a bullish contrast to the notable declines in the S&P 500 (SPY) and the NASDAQ (COMPQ) on the day, 0.9% and 2.0% respectively. Both major indices suddenly look toppy again.Once again, they printed what technical traders call bearish engulfing patterns, sometimes called major reversals. Only the surge in market breadth stops me from getting bearish (I remain neutral on the stock market per the last label in the S&P 500 chart below).

Now all the market needs is an actual rate cut from the Fed to give the celebration in market breadth some lasting power. As I noted when making the case to buy into the iShares MSCI BRazil ETF (EWZ), the market has recently sniffed out an imminent launch of a rate cutting cycle from the Federal Reserve. July 11th is the day the market practically forced the Fed’s hand. The odds of a rate cut for September jumped from 69.7% to 86.4%. The odds for staying right where they are dropped a lot closer to zero.

Source: CME FedWatch Tool

Now Back to the Inflation Story

While the celebrating over a negative handle on the headline CPI was market-moving, the headline CPI just continued an easily recognizable trajectory. Core CPI increased from the previous month and was up 3.3% year-over-year; both increases were lower than the previous month. The trend continues downward. Thus there was really no new news in the data. The trend is down, the trend is still the friend of the consumer.

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, July 11, 2024.

I earlier complained in “Fed’s Powell Avoids the Obvious: Inflation and Interest Rate Forecasts Make Little Sense” that Powell’s insistence that the Fed would cut once was inconsistent with a forecast indicating no progress on inflation. The core CPI continues to suggest that (overall) inflation’s days are dead for now.

Epilogue: TLT

The soft inflation numbers naturally drove bond yields down. The iShares 20+ Year Treasury Bond ETF (TLT) jumped 1.0% after fading from its highs of the day (TLT moves opposite the direction of yields). I used this opportunity to buy a fresh tranche of put options. I like fading TLT because the crushing levels of debt issuance periodically force yields higher and send TLT lower. Moreover, the economy is still able to generate enough inflation scares to send bond yields higher. Having said that, I have shifted the trade from a downtrend channel (shown in blue below) to a horizontal trading range (shown in black below). The first trade off this new presume range worked well as I took profits right at the top of the previous downtrend channel.

Of course a rate cut from the Fed could alter this trade all over again.

Be careful out there!

Full disclosure: long ITB, long SPY puts, long QQQ calendar call spread, long TLT put options, long EWZ

The post Now the Market Just Needs the Rate Cuts appeared first on Inflation Watch.

Nevermind that a read hotter than consensus has little impact on the current trend. The chart below from the U.S. Bureau of Labor Statistics shows that even as core CPI (all items less food and energy) is flattening out a bit (the red line), the “sticky” shelter component of inflation is still hurtling downward (the purple line).

With the trend still favoring the death of inflation, I think of “sticky” as a reference to people’s impatience with an inflation component taking too long to converge with the overall average inflation level. The CPI report highlighted the relative stubbornness of shelter inflation:

“The shelter index increased 0.6 percent in January, and was the largest factor in the monthly increase in the index for all items less food and energy. The index for owners’ equivalent rent rose 0.6 percent over the month, while the index for rent increased 0.4 percent. The lodging away from home index increased 1.8 percent in January…The shelter index increased 6.0 percent over the last year, accounting for over two thirds of the total 12-month increase in the all items less food and energy index.”

The bubble chart below from the U.S. Bureau of Labor Statistics shows the outsized influence of services less energy services on total inflation (the large purple bubble). This major component includes shelter. Its relative importance of 60.9 dwarfs the relative importance of all other major components of inflation.

Given the angst directed at the shelter component of inflation, I looked at what the National Association of Home Builders (NAHB) had to say about this CPI report. The industry group provided a reassuring conclusion: “the NAHB forecast expects to see shelter costs decline further in the coming months.  This is supported by real-time data from private data providers that indicate a cooling in rent growth.” So while the housing price picture is mixed with existing homes on the uptick and new homes on the downtick, overall rents should continue a cooling pace as expected.

Unfortunately for those traders and investors buying stocks and bonds in anticipation of rate cuts, this reminder of inflation’s stickiness pushed out expectations for the first rate cut from the Federal Reserve. Over-eager financial markets pushed out the first rate cut from May to June. This is a bitter pill to swallow for those who started buying stocks and bonds late last year in anticipation of a rate cut in March (because the Fed admitted to inflation’s death of course). The chart from the CME FedWatch Tool shows how the odds favoring a May rate cut immediately evaporated.

The Fizzle and Sizzle in Financial Markets

Interestingly, currency markets and the bond market have been moving counter to the rallies in the S&P 500 (SPY) and the NASDAQ (COMPX). The 2024 rally in the U.S. dollar index (DXY) has taken the index ABOVE the point where currency traders dumped the dollar in the wake of inflation’s death. The chart below from Tradingview.com shows a bullish breakout for the dollar last month above its 50-day moving average (DMA) (the red line) and a successful test of the trend line as support earlier this month.

The dollar’s rally complicates my bullish trades on the Canadian dollar but also provides my latest opportunity to fade USD/CAD (Invesco CurrencyShares Canadian Dollar Trust (FXC)) within the trading range. I am net long the U.S. dollar by being short EUR/USD (Invesco CurrencyShares Euro Currency Trust (FXE)).

Excluding a sharp countertrend rally at the end of January, iShares 20+ Year Treasury Bond ETF (TLT) has sold off most of 2024.

These trends further reinforce the notion and fear that perhaps earlier rate cut expectations were indeed premature. After the market’s pullback (the S&P 500 lost 1.4% and remains in an uptrend) will stocks also concede the point or will they return to ignoring deteriorating market breadth and other signs of caution in the stock market?

The volatility index (VIX) may have already blown off enough steam to soothe the groans of the bulls…for now. Note carefully how the VIX stopped going down this year and thus has an ever so slight uptrend going…

Be careful out there!

Full disclosure: net long U.S. dollar

The post From Inflation Fizzle to Sizzle appeared first on Inflation Watch.