Yesterday, the US reported headline and core CPI figures well below expectations. Stock markets around the world jumped, and the dollar got weaker as yields fell. The market cut its outlook for rate hikes. Commodities also got a boost. Is this the start of a new trend, or will the move fade? Let’s take a look under the headlines to better understand what is going on, and what could be coming.
The most important takeaway
As pointed out earlier in the week, the data has an important impact on expectations around future Fed policy. Before the release, economists were evenly split on whether the Fed would raise rates by 25bps or 50bps at their next meeting. After the release, the percentage of economists forecasting 25bps jumped to over 85%, with the market moving to price in a lower hike.
Not only that but the market reevaluated its terminal rate for Fed hikes. Before it was estimated that the Fed would hike to slightly above 5.00%. It currently is at 4.00%, meaning more than four 25bps moves until the end of the hiking cycle. Now, that has been repriced to the terminal rate being below 5.00%, so there would be a maximum of 100bps of hikes over the next five months. That is, according to current estimates.
The future trajectory
That could mean a 25bps in December, and then even the possibility of a pause in January. Or just three more quarter-point hikes. That substantially reduced yields on US treasuries, which in turn dragged down the value of the dollar. But, here’s the big question: Will this trend be sustained? Because right up until yesterday, inflation was rising. This could be just a short-term correction in a continuing trend – or the CPI figure could be revised with the next release.
Looking closer at the components of CPI, a few things stand out. First was the drop in rent, the largest contributor to the miss of estimates. Rent prices have declined in line with a major slump in the housing market, as higher interest rates have made buying homes more expensive. With house prices slowing down, rents aren’t rising.
Getting further into the details
The other two areas where there were unexpected price drops was in apparel and used vehicles. Both of these were driven by tighter financial conditions as Americans have seen their real wages fall for 18 consecutive months. With higher borrowing costs, it’s harder for Americans to dip into credit to buy things, as well.
With a stronger dollar, the cost of imported goods has gone down. But with expectations that the Fed won’t hike as much, the dollar would get weaker and imported goods would start costing more. We should remember that last quarter’s GDP was positive primarily because consumers were buying less imported goods. Such as apparel. If the dollar continues its downward trend, it could bring back core inflation and weigh on this quarter’s GDP result.
Although the immediate speakers from the Fed after the data release have hinted at lower rates, the bottom line is that the lower inflation reading depends a lot on interest rates. Over the next month, interest rate expectations might be lower and that could push inflation a little higher and change the evaluation of what will happen at the next Fed meeting. Remember; November CPI figures come out the day before the FOMC in December.
