Stephen Miller
Wednesday night’s April US consumer price index (CPI) report does contain some slivers of good news, particularly with regard to reduced price pressure in the services sector. However, the overarching conclusion is one of still only grudging progress in the fight against inflation. This comes after Friday’s April non-farm payrolls report indicated ongoing resilience in the labour market, including an unexpected acceleration in wage growth.
Bond markets staged a relief rally in the wake of the report but it remains the case that the bond market has consistently over-estimated the rapidity with which the inflation rate would decline and has consistently under-estimated how high the Federal Reserve (Fed) would take the policy rate and now how far the Fed is from contemplating any cut in the policy rate.
The April CPI certainly suggests that the peak in inflation is behind us. However, it does not indicate that progress is tracking at a pace any faster than embodied in current Fed forecasts. In that context, it looks some way from effecting any change in Fed intentions regarding cuts in the policy rate and will not discourage the continued espousal of the “higher for longer” message on the policy rate from Fed spokespersons.
In line with consensus expectation, the annual core CPI inflation rate fell slightly to 5.5 per cent from 5.6 per cent in March.
Measures of the ‘inflation pulse’ are indicative that peak inflation is behind us, but nevertheless remain elevated.
The 3-month annualised core CPI was 5.1 per cent in April, unchanged from March and still some above the recent trough of 4.3 per cent in December. More encouraging was the fall in the 3-month annualised Cleveland Fed trimmed-mean measure to 4.2 per cent in April (the lowest level since May 2021) and down from 5.2 per cent in March.
The big question regarding future inflation has been over the trajectory of services inflation. Here, there was some evidence of better news. The 3-month annualised rate of services inflation fell to 4.2 per cent, the lowest since October 2021.
As mentioned, despite somewhat better news on the services front, overall progress is not of a sufficient magnitude to effect a change in the Fed’s “higher for longer” path for the policy rate. However, the bond market now prices close to 75 basis points (bps) of cuts in the policy rate cuts in the second half of this year. That prognosis is not totally implausible but in my assessment it is certainly located at one end of the risk spectrum.
That pricing represents a widespread expectation of an imminent recession.
However, the Fed’s FOMC median forecasts have gross domestic product (GDP) growing at only 0.5 per cent this year and the unemployment rate rising to 4.6 per cent. That 0.5 per cent has already occurred in the first quarter. That means the Fed is implicitly assuming no growth between now and year-end. That is not inconsistent with a shallow recession (of which there are still only scant signs). That means it will take more than a shallow recession for the Fed to meaningfully change course.
As I have previously remarked, it would not surprise to observe persistent “stickiness” in inflation even if some of the cyclical inflation tailwinds are in some form of abeyance. The reversal of structural currents that account for the deflationary tendency of the past three decades is ongoing: viz; globalisation of labour supply (after the fall of the Berlin Wall and the “export” of labour from large emerging market economies such as China and India) is abating, globalisation of goods markets is in retreat as governments everywhere introduce protectionist measures under the guise of “industrial policy” and “national champions”, while domestic regulation of markets is increasing in scope (leading to upward price pressures) and baby boomer workforce participation is declining (limiting labour supply). The transition to clean energy involves ongoing costs to business, which is not to say it is undesirable, but it does complicate the task for inflation-focussed central banks.
The above has led me to view current US bond yields as over-extended on the downside and it would not surprise me to see bond yields grind higher as we approach the northern summer.
The one element that might validate the sort of view currently reflected in the bond market would be a more severe tightening in credit conditions than the notable tightening observable in the most recent Fed Senior Loan Officer Survey. That survey was consistent with further tightening of credit conditions (both on the demand for loans side and tighter lending standards) but was not as bad as feared and not (yet?) enough to effect a change in Fed intentions.
Just as the CPI has come roaring back into vogue as a key economic release, data relating to loan demand and lending standards as exemplified by the aforementioned Fed Survey are likely to be subject to intense ongoing scrutiny.
For the time being, however, the Fed’s emphasis remains on vanquishing inflation, and April’s numbers suggest that market hopes of policy easing remain overstated.
Coming up: Bank of England to hike 25bps
As with the other central banks, the Bank of England (BoE) must weigh up the balance between stubborn inflation, likely further tightening in credit conditions, and a significant deceleration (or worse) in economic activity.
However, partially reflecting some policy missteps earlier through 2022 the BoE is not as well-placed as the Fed in terms of inflation (and as remarked above the latter is still some way from being “comfortable”). That was underscored with the release of March inflation numbers that showed an acceleration of inflation well ahead of market expectations.
Headline inflation remained stuck at close to 40-year highs, coming in at 10.1 per cent (versus 9.8 per cent expected and a BoE target rate of 2 per cent). Core inflation was 6.2 per cent (versus 6.0 per cent expected).
The BoE has on occasion prevaricated in its commitment to the containment of inflation and reflecting that prevarication, it faces an increasingly intractable inflation problem.
The BoE will likely increase the policy rate by 25bps to 4.50 per cent. That is universally expected. However, the magnitude of the miss on inflation suggests that a 50bp increase might be on the table. It is likely, however, that foreshadowed declines in activity growth make that a bridge too far.
Nevertheless, given the extent of inflation inertia in the UK more policy rate hikes could well be in the offing. Indeed, the primary market focus of this meeting will be on any post-meeting communication that may give some indication of any future disposition on the part of the BoE to raise the policy rate further.
By Stephen Miller, investment strategist