Stephen Miller
A slightly higher-than-anticipated core inflation result probably means that a further increase in the policy rate is on the agenda for next week’s Federal Reserve Federal Open Market Committee (FOMC) meeting. Financial markets (and this writer) had anticipated a slightly better result, one that was sufficient to see the Federal Reserve (Fed) tightening cycle go into abeyance at next week’s meeting. At this stage, whether the FOMC does decide on a further policy rate increase is a finely balanced call.
Perhaps a little surprising was the relative equanimity with which the bond markets reacted, suggesting that markets aren’t convinced that the Fed will raise the policy rate next week.
Even if the Fed were to “skip” a policy rate hike at next week’s meeting, it will seek to give markets the message that further hikes remain an option and reinforce the “high indefinitely” mantra that it has attached to its recent commentary on the policy rate. That would imply that current Fed thinking does not contemplate any policy rate cuts until at least the second half of 2024.
In annual terms, headline inflation rose to 3.7 per cent from 3.2 per cent in July mostly reflecting the vagaries of base effects associated with energy prices. Core consumer price index (CPI) fell to 4.3 per cent from 4.8 per cent in June, its lowest since September 2021.
Measures of the ‘inflation pulse’ remain indicative that peak inflation is behind us, and meaningfully so. However, that the core CPI reading did not indicate quite as much progress as the Fed and markets may have hoped will reinforce existing concerns regarding the “stickiness” of inflation.
The 3-month annualised core CPI was 2.4 per cent in August, down from 3.1 per cent in July and was the lowest since March 2021 when economic activity was still in the throes of the pandemic. The 3-month annualised Cleveland Fed trimmed-mean measure rose slightly to 2.9 per cent in August from 2.7 per cent in July. The Cleveland Fed median measure fell to at 3.6 per cent, which is still slightly elevated, but is the lowest since July 2021.
However, the Fed may harbour ongoing concern regarding the “stickiness” of services inflation. The 3-month annualised rate of services inflation (or ‘pulse’) actually increased to 3.9 per cent from 3.6 per cent in July. A similar ‘pulse’ measure for services less energy showed a marginal fall to a still reasonably elevated 4.0 per cent for August from 4.1 per cent in July. Finally, the annual rate of services ex-rent of shelter fell slightly to 3.1 per cent from 3.3 per cent in July (the absence of seasonally adjusted data for this measure makes a ‘pulse’ calculation problematic). That “stickiness” in the service sector reflected the recent bounce-back in the “prices paid” component of the Institute for Supply Management (ISM) services Purchasing Manager Index (PMI).
On the positive side, the August CPI report overall indicates that progress in getting inflation down may be tracking at a slightly faster pace than embodied in the most recent Fed forecasts published in June, the “stickiness” in services notwithstanding.
Nevertheless, given the “stickiness” on the services side, and the Fed’s desire to keep inflation expectations anchored, even if the Fed chooses to “skip” a policy rate hike next week, it will continue to see considerable utility in continuing to telegraph a “high indefinitely” message and, as mentioned above, will almost certainly retain the option to increase the policy rate at future meetings.
In other words, the policy rate is at best at a “plateau” rather than a “peak”.
Finally, the higher than expected August core number may reawaken fears that renewed momentum in the economy is leading to some reignition of price pressures. That may lead markets to question the emergent ‘Goldilocks’ narrative: that the Fed could successfully “thread the needle” and engineer a relatively benign disinflation (so-called “immaculate disinflation”) without an excessive dislocation in activity and employment.
Coming up: ECB to raise the policy rate 25 bps at Thursday’s meeting
More so than usually, tonight’s European Central Bank (ECB) meeting looks to be a close call. My own view is that the prudent decision would be a further increase in ECB policy rates taking the rates on its deposit facility, main refinancing operations and marginal lending facility to 4.00 per cent; 4.50 per cent; and 4.75 per cent respectively.
Certainly, economic growth remains tepid but Eurozone-wide measures of inflation indicate that progress is some way short of what has been achieved in say the US. Indeed, media reports suggest that while the ECB has recently downgraded forecasts of growth, more importantly it now forecasts inflation to finish 2024 at 3.2 per cent, compared to the ECB objective of 2 per cent. That lack of progress reflects a greater degree of caution from the ECB when it comes to the task of inflation containment. That may in turn have been borne of an inevitable institutional inertia that attaches to organisations like the ECB that are forced to confront a disparate set of priorities among its members that are and difficult to reconcile.
As I commented last week, albeit in a slightly different context, the self-described “aged” 1970s ruminator, Niall Ferguson, wrote for Bloomberg some weeks ago that he “keeps having to remind people that the dream of pain-free disinflation was a recurring delusion of the 1970s”. In other words, the lesson from the ‘70s is that any delay on the part of a central bank in enacting a coherent and firm response to an inflation threat only heightens the risks down of a more damaging macroeconomic dislocation in terms of activity and employment down the track.
That is why I think the ECB should raise its policy rate(s) by 25 basis points when it meets this evening. And I suspect that view will prevail, particularly given the ECB’s own forecasts of ongoing “stickiness” in inflation.
However, I would expect ECB to give themselves some optionality regarding the extent and timing of any future policy rate increases, the communication of which might present as it being in “wait and see” mode as it contemplates its stance at future meetings.
By Stephen Miller, investment strategist
