Fed, Markets Fly Blind As Inflation Storm Seen Easing

It’s inflation week in the US.

Actually, every week is inflation week in the US, and all over the developed world too. So, I should specify: It’s CPI week in the US.

I’d call August’s data “pivotal,” but that wouldn’t be accurate anymore. Or at least not vis-à-vis the September FOMC meeting. Recent Fed rhetoric, including Jerome Powell’s painful (and, in my view, ill-advised) Q&A session with the Cato Institute, reinforced the unequivocal message from Jackson Hole: The Fed is operating on a single mandate and although officials habitually allude to optionality, it’s clear the Committee is leaning strongly in favor of a third consecutive 75bps hike this month. If there were lingering doubts, Wall Street Journal “Fed whisperer” Nick Timiraos looked to dispel them with a not-so-subtle article titled “Fed on Path for Another 0.75-Point Interest-Rate Lift.”

“The Fed has become more comfortable communicating tighter policy, with their message transitioning from ‘soft landing’ to ‘softish landing’ to one of ‘some pain’ for consumers and businesses,” TD’s Priya Misra and Gennadiy Goldberg said. “This suggests the Fed is likely to keep policy relatively tight for some time even after inflation begins to decline [and] also suggests the Fed will likely be ‘late’ to ease when growth begins to slow significantly.”

Consensus expects another deceleration in headline CPI (to 8% YoY), but core is seen ticking back above 6% (figure below).

“As evidenced by July’s CPI, shelter/OER continues to provide the pillar for core prices, a dynamic that will eventually moderate as the real estate market continues to cool and housing affordability eases the pace of home price appreciation,” BMO’s Ian Lyngen and Ben Jeffery said. “Alas, the pullback risk for shelter doesn’t come into play until later this year as the base effects become more relevant in Q4 and the lagged impact of the spike in home prices runs its course.”

Recent data, including July JOLTS (which showed job openings actually rose), August payrolls (which were robust), improving consumer sentiment and solid ISM prints (on both the manufacturing and services sides), almost uniformly suggests there’s ample scope for another jumbo-sized rate hike. It’s difficult to imagine August CPI changing anything in that regard. Markets are looking for another MoM decline on the headline index and a 0.3% monthly gain on core.

Notably, there are reasons to believe inflation in the US is in the process of peaking — only for real this time. TD pointed to recent declines on the Manheim wholesale index in suggesting used vehicle prices likely acted as a “significant drag on price growth,” said the suppliers’ delivery times gauge in S&P Global’s Composite PMI points to a drop in a CPI transportation component and flagged plunging freight and container rates (figures below).

TD sees headline US inflation falling back to 2% by June, but expects core to remain at (or at least near) 3% through year-end 2023. The bank expects both will remain above 4% through April.

I’d gently suggest that inflation doomsayers, having met with forecasting success beyond their wildest imaginations over the last 18 months, should take a step back and learn from the mistakes of those over whom they triumphed. It’s true that five-handle inflation is a foregone conclusion for the rest of 2022, but beyond that, it’s much harder to map.

Some Fed critics and fiscal hawks are beginning to sound quite a bit like the overconfident policymakers they’ve spent the last two years deriding. Forecasting inflation outcomes isn’t going to get any easier going forward. Speaking deterministically based on recency bias is precisely what got central bankers into trouble post-pandemic.

To be sure, I’m inclined to believe macro volatility is indeed here to stay and that inflation is likely to be biased higher as a result. But Fed critics should be wary of the same hubris that befell central bankers.

Note that five-year breakevens are now more than 100bps below the March highs (figure above). As BlackRock’s Rick Rieder told Bloomberg last week, “if inflation comes down to what breakevens are pricing today, then a soft landing is possible.”

PMI price gauges have come down markedly, and commodity prices remain under pressure from the surging dollar and concerns around Chinese demand. Were it not for a Friday gain helped along by a break in the dollar’s inexorable rise, the Bloomberg Commodities Index would’ve notched a second consecutive large weekly decline. It still fell slightly, and is well off 2022’s highs (figure below).

Oil is, of course, down dramatically from this year’s nosebleed peak, and the Saudis aren’t pleased about it. Vladimir Putin issued what we’re all supposed to call a “stark” warning last week about the likely ramifications of the G7’s efforts to cap Russian crude prices. Risks are skewed to the upside, and I certainly wouldn’t want to suggest otherwise, especially given the distinct possibility that battlefield losses for the Russian military could tempt the Kremlin to resort to more extreme tactics which risk dragging the Western powers into the conflict directly. For now, though, oil is on the back foot, in part because the paper and psychical markets are detached.

Traders will also eye PPI in the US this week for evidence of moderating pipeline pressure, while retail sales, due Thursday, will give markets another chance to assess the health of a US consumer who, despite trading down and shifting consumption away from discretionary goods in light of inflation realities, is generally unbowed. The precipitous drop in gas prices may have bolstered households in August, and the preliminary read on University of Michigan sentiment for September, due Friday, may suggest consumer psychology continued to improve early this month, albeit from record low levels.

Also on deck: NFIB, the Empire and Philly Fed gauges and a front-loaded auction schedule. The Fed’s in their pre-meeting quiet period, which, coming full circle, means it’d take an unthinkably benign inflation report to shift expectations materially back in favor a 50bps move at the September FOMC.

“Amidst a plethora of uncertainties — a resilient economy, persistently high inflation and a hawkish Fed — it is difficult to have a strong conviction on the Fed’s policy path or the timing of a recession,” SocGen’s Subadra Rajappa wrote. “Strong employment and the recent rebound in consumer sentiment (owing to lower gas prices) bolsters the case for more rate hikes [which] should keep front-end yields high and sticky as the Fed keeps policy restrictive, but the end goal of tighter policy is demand destruction and slower growth,” she added.