Inflation Preview: CPI Seen Slowing Sharply, 2% Fed Target In Sight

U.S. inflation likely slowed to the weakest pace in more than two years last month, while rapidly approaching the Federal Reserve’s 2% target, as the impact of previous rate hikes, and a slowing economy, continues to erode consumer price pressures.

Wall Street forecasts suggest headline consumer prices rose 3.1% over the month of June, compared to the four-decade high of 9.1% recorded over the same period last year and the 4% pace reported in May.

On a monthly basis, Street forecasts pegged headline CPI at 0.3%, a nudge faster than the 0.1% pace tallied in May thanks in part to higher gas prices, with core easing to 0.3% from 0.4%.

The Fed has lifted its base lending rate by 5% since last year, to the current range of between 5% and 5.25%, in an effort to tame an inflation surge that many economists had tied to supply chain disruptions linked to the global Covid pandemic and the impact of higher energy prices triggered by Russia’s invasion of Ukraine in the winter of 2022. 

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The rate hikes themselves, alongside the sale of bonds from the Fed’s $9 trillion balance sheet, comprised one of the most aggressive policy efforts in a generation and were aimed at blunting demand in the hope that it would cool consumer price pressures.

“With 70% of excess savings built up over Covid gone, more and more people are entering the workforce,” said Bryce Doty, senior vice president and senior portfolio manager at Sit Invest. “As a result, logistical supply shortages are dissipating along with the inflation those shortages were causing.”

“Inflation is crossing the critical level where it will be below the Fed funds rate which is an indication of an even more restrictive Fed policy than simply being higher than a 3% “neutral” interest rate,” he added.

Rate Hike ‘Lag Effects’

The impact of the Fed’s run of rate hikes, which were briefly paused last month as the central bank opted to assess incoming wage and inflation data, has been mixed: the economy flirted with recession over the autumn of last year, but has largely powered ahead on the back of a resilient labor market and sustain consumer spending. 

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Headline inflation has also been on a consistent downward trend since peaking at 9.1% in June of last year, falling for 12 consecutive months to its current pace of 4%.

Core consumer prices, however, which strip out volatile food and energy components, have remained stubbornly high, peaking at 6.5% in August of last year and only easing to 5.3% at the last calculation in May.

A big decline in used car prices, one of the thorns in the side of policymakers for several months, could elicit a big decline in June core inflation, however,  following data from Manheim Market Insights that showed that wholesale used vehicle prices fell by a record 4.2% in June, and were down 10.3% when compared to last that. 

Fed Sees More Work To Do

Still, New York Fed President John Williams told London’s Financial Times Tuesday that the U.S. economy would need to experience “pretty slow growth”, with a peak unemployment rate of 4.5%, to get inflation back to the Fed’s 2% target.

The Bureau of Labor Statistics pegged headline unemployment at just 3.6% last month, after tallying 209,000 net new jobs that lifted the year-to-date total to just under 1.7 million, down around 36.3% when compared to the same six-month period last year.

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“We are not getting the full effects of the restrictive policy that we put in place yet,” he told the paper. “Those are still ahead of us, although we have gotten some of the effects already in certain interest-rate sensitive sectors.”

That so-called ‘lag effect’, which suggests a delayed response to central bank rate hikes, is part of the reason why officials are calling for at least two more increases between now and the end of the year, even as headline inflation looks set to fall further over the summer months. 

“We’re likely to need a couple more rate hikes over the course of this year to really bring inflation”, San Francisco Fed President Mary Daly told an event at the Brookings Institution in Washington last night. “We may end up doing less because we need to do less; we may end up doing just that; we could end up doing more. The data will tell us.”

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Market data, meanwhile, suggests interest rate traders are fully-pricing in the chance of a July rate hike, with the CME Group’s FedWatch indicating a 95% chance of a quarter point increase later this month, a move that would take the benchmark Fed Funds rate to between 5.25% and 5.5%.

A follow-on hike, however, remains up for debate, with the odds pegged at only 20.9% for the September meeting and around 38% for November.  

Overall bets, in fact, suggest the July hike will be the Fed’s last, as inflation pressures ease further, hiring slows and broader economic growth falters.

Bonds Flash Recession Warning 

The Atlanta Fed’s GDPNow forecasting tool, a real-time tracker of economic growth, suggests the economy is currently growing at a 2.3% clip, following on from the 2% pace recorded over the three months ending in March.

However, a sharply inverted Treasury bond yield curve, which has interest-rate sensitive 2-year notes trading 88 basis points north of 10-year notes, has been flashing recession warnings for several months.

According to a study from the San Francisco Federal Reserve, a sustained inverted yield curve has preceded all of the nine recessions the U.S. economy has suffered since 1955, making it an extremely accurate barometer of financial markets sentiment. 

“Wage growth is likely to soften over the next few months, but this Fed is not in
the forecasting business; they are choosing to drive policy
decisions with backward-looking data, and those data are
not yet consistent with inflation returning to the target,” said Ian Shepherdson of Pantheon Macroeconomics.

“We think the picture will be different by the time of the
September meeting, following two full rounds of labor
market and inflation data, most of which is likely to be
favorable,” he added.

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