The slowdown in inflation provides the Fed with flexibility regarding future rate increases, but the easing of financial conditions may not be welcome.
It was reasonable to suspect that the July CPI would not be unexpectedly high because there was no pre-apology or explanation from the White House and no Fed official did a warlike haka dance to re-prove their inflation fighting bona fides immediately preceding the report. That said, the report still surprised with inflation easing, especially core CPI, which was broadly expected to remain troublesome. We knew that energy prices were declining, but seeing pressure subside for subgroups including used vehicles was additional favorable incremental news and should be celebrated. The immediate reaction from markets broadly was very strong with both equity markets and Treasuries, especially in the front end, rallying. The easing of financial conditions likely annoys the Fed, and we should not be surprised to see Fed speakers continue to try to talk down the market and risk assets.
Last Friday’s ‘so good its good’ jobs number supported the idea that a soft landing was still possible, and goldilocks may outsmart the three bears that have troubled equity markets, fixed income and liquidity.
The Federal Reserve now has something it hasn’t had in months: flexibility. With two months between meetings, the central bank has some breathing room for additional data to flow in and won’t be forced to react to any one strong or weak data print. The strong jobs number could also provide some cover and allow another hawkish hike, though the CPI number argues for a more measured Fed approach. Given this give and take, expect volatility to remain elevated over at least the near-term.
The market may be starting its fourth stage of its reaction to inflation. First denial, then anger, then euphoria and now maybe some acceptance that while inflation may be declining, it remains uncomfortably elevated. The focus and debate should continue to revolve around the rate of change of inflation and the reaction function of the Fed.
U.S. CPI and Core CPI (Y/Y % Change)
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