Financial markets have not seen much of a lasting reaction to the release of the latest US Consumer Price Inflation (CPI) report for the month of June. In fairness, the dollar is a tad lower now, with the Dollar Index (DXY) now back below 93.00, US yields are off earlier highs with the 10-year back around 1.35% having been as high as 1.38% earlier in the session. US equities, meanwhile, saw a firm open, with the S&P 500 coming very close to hitting 4450 for the first time. With regards to the inflation report, the YoY rate of headline CPI came in a tad higher than expected at 5.4% versus consensus expectations for a drop to 5.3%, unchanged from the month prior, whilst Core CPI printed in line with consensus expectations at 4.3%, down from June’s 4.5%. However, MoM measures of inflation saw a substantial drop in July versus June; the MoM rate of headline CPI dropped to 0.5% from 0.9% in June (as expected), whilst the MoM rate of Core CPI dropped to 0.3% from 0.9% in June, a larger drop than expected.
Based purely on these headline inflation figures, the drop in the MoM rate implies that inflation as a result of the vaccine enabled “reopening” of the US economy has peaked. Market participants who believe in the “inflation is transitory” narrative (i.e. the idea that after a brief spike in 2021, inflation will moderate quickly to more tolerable levels), which is the narrative that has been pushed by the Fed, will be emboldened by this. Indeed, this is perhaps why markets saw a modestly dovish reaction to today’s data; because some market participants might be taking this data as early evidence that the transitory argument is going to end up the correct one, meaning the Fed will be in less of a rush to eventually start hiking interest rates. That is one take; alternatively, the move being seen across markets might just have more to do with post-data position-squaring. After all, for the most part the data was pretty much in line with expectations and some analysts said the data also likely matched what the Fed had been expecting; hence the lack of follow through in the market reaction (the dollar is still not too far from multi-month highs, for instance).
The arguments about what is going to happen to inflation in the coming months, and what the Fed policy response might be, becomes more nuanced when you dig into the internals of the inflation report. Transitionists (i.e. those convinced inflation is going to fall back to more “normal” levels), will point to used car prices; the sharp rise in this component seen over the April to June period, all but halted in July. This may be taken as evidence that the impact of government stimulus cheques (which often went toward big-ticket purchases like used cars) is fading. Moreover, travel-related service prices, such as rental car prices and airfares, also moderated, with prices of the former dropping 4.6% on the month and of the latter remaining flat. This may be taken as evidence that re-opening effects are moderating. Meanwhile, the 2.4% rise in gasoline prices in July is unlikely to be replicated in August given the recent pull-back from post-pandemic highs in crude oil prices in recent weeks.
On the other hand, those arguing that inflation is likely to remain sticky at elevated levels also found evidence to support their arguments. Owner’s equivalent rent (OER), which makes up 24% of the headline index, rose 0.3% in July and analysts are saying that it is finally starting to reflect the sharp rise in house prices observed since the onset of the pandemic. Wells Fargo note that “with OER lagging sale prices by roughly a year and a half and the inertia in this category, we expect shelter costs to be an increasing source of inflation ahead”. Meanwhile, the MoM pace of inflation amongst a number of the key components that make up Core CPI were also elevated in a sign that businesses are finding it easier to pass costs onto the consumer. As the labour market continues to tighten over the coming months, this is unlikely to change, and Wells Fargo also think this will feed into an uptick in Rental costs.
What the latest inflation data means for markets going forward…
As outlined above, there was something for everyone in this latest inflation report. That means the great inflation debate remains far from resolved and market participants remain divided over whether inflation is going to prove sticky at higher levels for longer than the Fed expected, which would them to start hiking interest rates earlier than they currently forecast. FOMC members have been sounding more hawkish recently, with many openly calling for a prompt tapering of the bank’s QE programme. The main motivation of this for most seems to be the progress being made towards the Fed’s mandate of full employment, rather than concerns about inflation being too high. However, the fact that inflation continues to persist at such elevated levels (remember the bank’s inflation target is for 2.0%) seems to be a growing concern, reflected in a change in language from key FOMC members who now seem to be characterising risks to their inflation forecast as tilted to the upside. If inflation does remain at persistently high levels (i.e. above 3.0%) well into 2022, then that sets up the prospect of a hawkish shift in FOMC policy guidance towards rate hikes next year.
Though this latest inflation report does seem to have offered some early evidence that inflation is has peaked, peaking is not going to be good enough to stop a hawkish FOMC shift. Hence, the US dollar should remain supported for now, particularly versus the currencies of its central bank counterparts who are well behind the bank in terms of monetary policy normalisation (like the ECB, BoJ and SNB). For the dollar to weaken, a substantial drop in inflation back towards the FOMC’s 2.0% target is likely going to be needed. That means it will be crucial to watch the inflation metrics over the coming months. Any evidence of persistent inflation at levels that will get the Fed hiking rates early is going to be USD supportive and is also likely going to push US bond yields higher. Expect this to weigh on gold and “growth” stocks (i.e. stocks whose high valuations rely in part on low bond yields like Big Tech).