Stephen Miller

US CPI: Groundhog day as core inflation surprises on the upside again

At the start of the year the bond market was anticipating something close to 175 basis points (bps) of policy rate cuts or seven different episodes of 25 bp cuts. To put that in perspective that would have required a rate cut at every meeting following the Federal Reserve’s (Fed) meeting concluding on 31 January. In other words, the Fed was expected to have commenced cutting the policy rate in March.

“Sticky” inflation and a resilient labour market have substantially diminished the bond markets prior enthusiasm for policy rate reductions. Indeed, leading into the release of the March consumer price index (CPI) markets and the Fed (judging by the March “dot plot”) were reasonably aligned in their view of three policy rate reductions this calendar year.

Since the commencement of the policy tightening process in early 2022, markets have exhibited an ongoing predilection to “false start” on rate cuts based on an overly optimistic assessment of the rapidity with which inflation might decline or an overly pessimistic assessment of the resilience of activity growth and the labour market. That is despite a litany of disappointments on inflation.

In the post-pandemic period, the aftermath of inflation reads has generally led to an eerily familiar revisitation of rate cut expectations as markets temper their policy rate cut expectations. This brings to mind the film Groundhog Day where events repeatedly unfold in a way that has happened before.

The US March CPI fits that mould.

This time around, however, it may be that the market and the Fed will need to reassess the expected quantum of any policy rate reduction, if any, this calendar year.

At the close of business, the bond market now was pricing somewhere between one and two Fed rate cuts this year from the almost three cuts priced prior.

After seeming to get ahead – or at least draw level – with the inflation challenge, Fed Chair Powell might arguably be characterised as too complacent.

Measures of the “inflation pulse” indicate ongoing and troublesome “stickiness” in inflation.

The 3-month annualised core CPI was 4.5 per cent in March, a stark deterioration from a trough of 2.6 per cent in August 2023, and was the highest since May last year. The 3-month annualised Cleveland Fed trimmed-mean measure rose to 4.5 per cent in March from a trough of 2.8 per cent in July 2023, and was the highest since March last year. The 3-month annualised Cleveland Fed median measure remained elevated at 5.1 per cent.

The March CPI report will reinforce ongoing concern regarding the “stickiness” of services inflation. The 3-month annualised rate of services inflation (or “pulse”) was 7 per cent, the highest since February 2023. The admittedly volatile services less rent-of-shelter measure rose to an eye-popping 8.7 per cent, the highest since July 2022.

Arguably, these trends are more than indications of “stickiness”. Rather they border on indications of a reversing of the disinflation trend that appeared to emerge from around the middle of the year.’

The March CPI was a reminder that the process of disinflation tends to be more disjointed: a process of “two steps forward and one step back” with the “last mile” to the inflation target proving particularly challenging, particularly in an environment (such as in the US) where economic activity is resilient.

There are other key structural elements at work that will make that “last mile” even more daunting.

The 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”; domestic regulation of goods and labour markets is increasing in scope (leading to upward price pressures); and baby boomer workforce participation is declining (limiting labour supply and lifting wages).

The Fed must still be some way from contemplating any policy rate cuts and there is a real prospect that rate cuts might not come until 2025.

Even with two and 10-year US Government bond yields approaching 5 per cent and through 4.5 per cent respectively, bond markets might still need to make more room for such an eventuality. Even more significant price adjustments may need to occur for “riskier” assets.

Inflation developments aside, the “neutral” interest rate appears to have risen from the abnormally low levels that applied post-Financial Crisis through to the end of the pandemic.

Certainly, the resilience of activity and the labour market during the recent Fed tightening cycle is suggestive of the notion that the “natural” real growth rate has increased from that in the preceding 15 years or so, and that, accordingly, the “neutral” real interest rate should also have increased.

Other observers point to other emergent secular trends that might have pushed (and continue to push) the “neutral” real interest rate upwards: larger US budget deficits; investment demands on the savings pool from clean energy investments; and boomer retirees de-accumulating savings.

But getting back to inflation, there is now arguably some nascent (and likely small) risk that the Fed goes down the path of the ill-fated Arthur Burns / G. William Miller led Fed of the late 1970s. Of course, the orders of magnitude involved in terms of policy mistakes and their consequences are currently much less but there is the genesis of a parallel.

Having said that, Powell has a large store of credibility and has exhibited considerably sage judgement over the past couple of years even if with the benefit of hindsight, he now appears to have been overly eager to embrace a policy rate cut scenario.

Financial markets, US households and probably President Biden are hoping that his sagacity remains intact.

No surprises from the RBNZ; the Bank of Canada opens the rate cut door

Not much by way of surprise from the Reserve Bank of New Zealand (RBNZ) and the Bank of Canada which held their policy rates steady at 5.5 per cent and 5 per cent respectively.

The RBNZ pushed back against any notion of a near-term cut in rates.

The Bank of Canada, however, reflecting its superior progress on inflation opened the door to a June policy rate cut. Bank of Canada Governor described a June rate cut as “within the realm of possibilities,” but added that was conditional on further progress on inflation.

Tonight’s European Central Bank (ECB) meeting is a little more interesting.

In contrast to the US, Eurozone inflation continues to surprise on the downside.

In essence that reflects weak economic activity, partly driven by Europe’s vulnerability to the ongoing fallout from the Russia / Ukraine conflict and deep structural growth weaknesses.

Eurozone March core CPI came in at 2.9 per cent which was a modest downside surprise from the expected 3 per cent, albeit that that expectation itself reflected previously released downside surprises in Eurozone national CPIs.

The inflation data supports expectations the European Central Bank (ECB) will cut policy rates in coming months.

ECB President Christine Lagarde has previously stated that “we will know a bit more by April and a lot more by June”. At this stage a cut in the ECB policy rates looks unlikely with the rates applying on the deposit facility, main refinancing operations and marginal lending facility remaining at 4.00 per cent; 4.50 per cent; and 4.75 per cent respectively, but Lagarde is likely to frame the decision as a “dovish hold” and intimate a strong likelihood of a June reduction.

That said, with the Swiss National Bank (SNB) surprising with a March cut in their policy rate, and given dire activity growth, the prospect of an ECB rate cut in tonight – while a certainly a surprise – cannot be completely ruled out.

By Stephen Miller, investment strategist

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