CPI inflation has finally peaked, we’re sure to find that out on Wednesday morning. Falling gas prices, retail rebates, the return of online deflation and a collapse in shipping costs suggest there will be a fairly quick pullback from the 40-year high of 9.1% in inflation in June.
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The combination of a spike in inflation and a move away from the Fed’s hawkish stance provided an antidote to the bear market. After strong rallies since mid-June, the Dow Jones and S&P 500 have both exited bear market territory. Only the Nasdaq loss still breaks the 20 percent bear market threshold.
But Friday’s strong jobs report has reined in the upside. Can a falling inflation rate give it new jump-starts?
CPI inflation rate forecast
Wall Street economists expect CPI to rise 0.2% in July after rising 1.3% in June. The annual inflation rate is expected to fall from 9.1% to 8.7%.
However, core inflation, which excludes food and energy prices, is not expected to show much moderation. Core CPI is expected to rise 0.5% on the month after rising 0.7% in June. Core inflation is expected to rise to 6.1% from 5.9%, with rising accommodation costs being a major contributor.
inflation rate expectations
Nevertheless, not only headline inflation is falling, but also inflation expectations. The New York Federal Reserve’s Consumer Sentiment Survey released on Monday showed that the three-year median inflation expectation fell to 3.2% from 3.6% in the previous month. Inflation expectations for the next five years fell from 2.8% to 2.3%.
The reason that matters to policymakers is that inflation is penetrating consumer psychology, influencing shopping behavior and even negotiating wage increases. The more inflation entrenches, the harder it is for the Fed to root it out.
With signs that consumers are less concerned about the prospect of persistently high inflation, the Fed will have less need to accelerate rate hikes.
No more Fed forward guidance
Back on July 27, Fed Chair Jerome Powell said policymakers had suspended forward guidance. They go from meeting to meeting, using the latest data to decide the appropriate policy setting. What has changed? As the Fed rates approach neutral and move into hawkish territory, policymakers will tend to slow down. This is particularly the case as signs of economic weakness have spread from home construction to consumer spending to corporate fixed investment.
The next Fed rate hike: 50 or 75 basis points?
Right now, Wall Street sees a 67.5% chance of another 75 basis point rate hike when the Fed next adjusts monetary policy on September 21st. Those odds skyrocketed after Friday’s unexpectedly hot jobs report.
Here’s the good news: The odds of a larger move may be overstated.
The decision to hike 75 basis points at each of the last two Fed meetings “was driven by rising inflation expectations, which have since declined significantly,” wrote Jefferies financial economist Aneta Markowska.
We also have a second soft CPI report ahead of the mid-September Fed meeting. At this point, as energy prices continue to fall, Markowska sees the potential for August prices to contract by 0.2% from July.
The Fed’s focus is shifting back to core inflation
As oil prices continued to soar, Powell appeared to downplay the Fed’s usual focus on core prices, saying the concept was unfamiliar to households struggling with inflation.
Now that oil prices are falling, Powell’s focus is back on core inflation. “Core inflation is a better predictor of future inflation,” Powell said in his July 27 news briefing.
“Core inflation should also ease in the coming months amid overwhelming evidence of a reduction in supply chain pressures,” Markowska wrote. But she expects core services inflation “to remain sticky, helped by tightness in housing and labor markets.”
Non-energy services, or core services, account for 57% of consumer budgets, led by housing and healthcare, according to the Department of Labor. Inflation in these categories hit a 30-year high of 5.5% in June.
Recession sentiment deepens for US economy: IBD/TIP
Two Economy Paths After Jobs Report
The Dow Jones’ initial reaction to the July jobs report was muted, in part as markets waited for weak CPI inflation data this week. However, the hoped-for Fed pivot seems a long way off. It is clear from the report that the labor market is tight as a drum. If hiring really is as strong as the reported 528,000 job gains suggest, then the Fed has a lot of work to do.
Deutsche Bank economists say the jobs numbers “reinforce our above consensual call for a 4.1% policy rate, to which the market now appears to be waking up.”
The other possibility is that the employment data overestimates the strength of the labor market. The Labor Department’s household survey shows the number of employed people has fallen by 168,000 in the past four months, although the employers’ survey shows 1.68 million new jobs.
But even if the labor market is weaker than it appears, there is no reason to doubt the employment report’s indication that the labor market is extremely tight. If this is the case, wage pressures and core inflation could subside more slowly. The Fed could stop tightening sooner, but a turn towards rate cuts and an end to balance sheet tightening could take a while.
Dow Jones rally on hold?
Following Friday’s jobs report, financial markets are pricing in another quarter-point rate hike to a range of 3.5% to 3.75% by early next year. By mid-2023, the odds in the financial markets are tilting towards looser policy. But a higher interest rate makes the path to a soft landing all the more difficult. It suggests higher chances that the Fed will overshoot, leading to a recession and a drop in earnings.
On Tuesday, the Dow Jones slipped 0.2% and the S&P 500 slipped 0.4%. The Nasdaq, which had outperformed for the past few weeks, returned 1.2%.
Having already had a strong rally, some weak core inflation readings may be needed to reignite the bulls.
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