US Inflation: The Big Misread
(4 min read)
(4 min read)
US inflation figures for July came out yesterday, surprising to the downside. The annual Consumer Price Index (CPI) slowed to 8.5%, down from 9.1% in June. MoM, it was lower than expected at 0% for headline and 0.3% for core. And on a six-month annualized basis, core inflation dropped from 6.8% in June to 6.3% in July.
The market response was wild. The S&P 500 surged to a three-month high while the NASDAQ entered a bull market, up 20% from a June low. The surge came as investors read the low print as a signal for the Fed to turn more dovish on interest rate hikes.
But we disagree – for two reasons. First, a closer look at inflation reveals it is still accelerating. And second, a one-off low print does little to distract from an economy under immense resource pressure, with the latest NFP hinting at an acceleration in growth and, therefore, more room for the Fed to keep hiking.
Headline may have been down, but broad inflation pressures eased little. We see this in the trimmed mean and median price CPI, which ignore the largest price changes (Chart 1). Those have become more reliable indicators of trend than core inflation. This is because large and repeated supply shocks have raised core inflation volatility.
Core goods price inflation slowed, and core services inflation accelerated. Core goods price inflation remains on track with my forecast of a slowdown to about 4% YoY by end-2022. Core services inflation, by contrast, accelerated YoY to 5.6% from 5.5%, though it slowed MoM and 6m saar.
Despite a smaller acceleration in core services inflation this month, I am not changing my forecast of end-2022 services inflation around 6%. This is because, historically, core services inflation and wages growth have been strongly correlated, and wage inflation is still accelerating (Chart 2).
Friday’s NFP showed an acceleration in the growth of average hourly earnings to 0.5% from 0.3% in June. And most importantly, the NFP showed a decline in unemployment spurred by falling participation, suggesting wage growth is likely to accelerate further.
Following the CPI print, Charles Evans and Neel Kahskari, two of the more dovish FOMC members, clarified that they continued to expect the Fed to hike this year and into next year. Nevertheless, the market promptly shaved off 7bp from the end-2022 federal funds rate (FFR) and 3bp from the end-2023 FFR. Overall, at 3.5%, the end-2022 FFR remains consistent with the Fed’s June Summary of Economic Projections, but the end-2023 FFR at 3.1% is well below.
I see too little news in the print to change my expectations of a 75bp hike at the September FOMC meeting and 175bp by end-year. The broader macro picture remains that of an economy with exceptional resource pressures. Also, the July NFP may well be the first sign of an acceleration in growth. And, as far as the Fed is concerned, there is still one CPI and one NFP print before the September FOMC.
Overall, the market is still underpricing the extent of the US inflation problem. I expect more hikes ahead and therefore the risk rally to end in autumn.