Today’s July CPI inflation numbers showed headline and core inflation both falling, a little more than was expected.
But don’t expect the Fed to signal an easing of policy. It will want to stand firm on its interest rate hikes and quantitative tightening (QT) until there is visible slack in the labour market, which is proving hard to achieve.
The fall from 9.1% to 8.5% in headline CPI will, of course, be welcomed by the Fed. It offers reassurance that the worst may be over for the inflation story.
Investors have warmed to this theme, with Treasury yields falling across the curve today. US and global stock markets have rallied in response to the news, with the more interest-rate sensitive NASDAQ outperforming the S&P 500 index.
And market expectations of where Fed rates will peak in the current cycle fell in the hours after the data release, from 3.6% to 3.4%. Since they currently stand at a target range of 2.25% to 2.5%, just two more 50bp hikes would be needed…one can almost hear investors sigh, ‘we’re almost there!’
But the Fed has good reason to remain cautious. And therefore, so should investors.
The cause of the fall in U.S inflation was largely weaker energy prices, which are finally rolling over on a year-on-year basis (and were down compared to June). Other supply-side shocks are also easing; for example, the microchip shortage that had led to shortages of goods has turned into a glut.
But as one source of inflation fades, another grows.
U.S inflation is now being driven by domestic demand. A red-hot labour market, with unemployment at just 3.5%, is pushing up wages which rose over the second quarter to an average of 5.3% over the previous 12 months. And last week’s strong payroll numbers suggest that the tighter financial conditions engineered by the Fed have not yet impacted (although vacancy rates are down).
If the labour market remains tight, we will likely see inflation remaining stubbornly high, and markets will have to start pricing on the risk of a wages/prices spiral setting in.
It is much too early to expect the Fed to declare victory over inflation. It may have peaked, but there is a continuing risk of staying at relatively high levels for longer than the market believes.
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