Inflation Good Surprise

Inflation finally surprised markets in a good way, and traders are understandably enthusiastic that the worst price pressures may finally be in the rear-view mirror.

The Labor Department on Wednesday said the consumer-price index, a measure of what consumers pay for goods and services, rose 8.5% in July from the same month a year earlier, down from 9.1% in June. Monthly, the CPI was flat in July after rising for 25 consecutive months, the result of falling energy prices such as gasoline. Core CPI, which excludes often-volatile energy and food prices, eased to 0.3% last month, down sharply from June’s 0.7% gain. Inflation might finally be cooling. By one measure, the consumer price index was unchanged in July. There was 0% inflation month over month, down from a 1.3% increase the previous month. But that’s not the number getting the most attention. It’s the first time since early 2021 that the consumer price index headline reading was lower than expectations.


Inflationary pressures in the US simmered down on the heels of cheaper gasoline and other fuel costs. The average national price of a gallon of regular unleaded gasoline fell to $4.00 on Wednesday, more than $1 cheaper than in mid-June but still higher than a year ago, according to OPIS, an energy-data and analytics provider owned by Dow Jones & Co., publisher of The Wall Street Journal.


The lower-than-consensus CPI number sparked another sharp rally in the stock market, and it took the S&P 500 index slightly above its early June highs. This is certainly a positive development, but we’re still going to have to see a bit more upside follow-through to confirm that this all-important index is indeed making a “higher high.”


While the headline rate of inflation declined from the previous month, largely due to a drop in energy prices, the surging cost of food, as well as rising rents, continue to pinch consumers, especially low-income Americans who spend a bigger chunk of their household budgets on groceries. Food prices in the US soared in July, keeping the cost of living painfully high even as lower gasoline costs offered some relief to consumers. Overall food prices climbed 10.9% from a year earlier, the biggest increase since 1979, according to data published by the Labor Department on Wednesday. Several essentials like cereal and certain dairy products posted record year-over-year rises.


With rents still pushing higher and elevated wages beginning to seep into services inflation, we expect this pause to be short-lived. Core CPI could approach 7% in the coming months despite our assumption of moderation in goods prices. Shelter costs which are the biggest services component and makeup about a third of the overall CPI index -- rose 0.5% from June and 5.7% from last year, the most since 1991. That reflected a 0.7% jump in rent of primary residence. Hotels, meanwhile, fell 3.2%.


Friday, Richmond Fed President Thomas Barkin said he was undecided on whether the Federal Open Market Committee should raise rates by 50 basis points or 75 basis points in September, with another month of employment and inflation data to come before the meeting. San Francisco Fed President Mary Daly the previous day predicted a half-point hike in September but said she was open to a larger move. Minneapolis Fed President Neel Kashkari, who prior to the pandemic was the central bank’s most dovish policy maker, said Wednesday that he wants the Fed’s benchmark interest rate at 3.9% by the end of this year and at 4.4% by the end of 2023.

The Fed wants to continue to see financial conditions do the work for them. Financial conditions are looser now than they were when the Fed began the rate hike cycle back in March leading us to believe that the Fed is not inclined to put on the brakes yet.

The swap contract referencing the September meeting by the end of last week priced in about 60 basis points of tightening, suggesting that a half-point hike is viewed as certain, with an additional quarter-point given odds of about 40%. 

As shown in figure 1



The personal consumption expenditures index (PCE), which the Fed uses for its inflation target, is seen averaging an annualized 2.5% at the end of next year, up from 2.3% in July, the latest Bloomberg monthly survey showed. Perhaps a more troubling sign of the broad-based nature of inflationary pressures, economists project the year-over-year core PCE price gauge, which strips out volatile food and energy costs, to average 2.9% in the fourth quarter of next year, up from last month’s 2.6%.

Respondents in the university’s consumer sentiment survey now expect prices to rise 5% over the next year, down slightly from 5.2% in the previous report, according to preliminary results released Friday. In the long run, respondents expect prices to rise 3% over the next five to 10 years, up from 2.9% previously. 

The Fed also closely monitors inflation expectations since they risk becoming a self-fulfilling prophecy. Consumers expecting higher prices may spend more now, keeping demand elevated and further testing the productive capacity of the economy. Businesses, which are already experiencing higher labor costs, may respond by raising prices further.


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