Is the Fed one more hike away from ending the current tightening cycle?
The lastest CPI numbers raise hopes the Fed will pause after delivering a final interest rate rise later this month
Today’s US CPI numbers finally provided the Fed with the readings it has been waiting for, following the fastest pace of monetary tightening since Volker in the 1980s. Both the headline and core rates came in softer than expected, the annual headline rate falling to 3.0% while the annual core rate dropped below 5% to 4.8%. On a monthly basis both the headline and core rates rose by just 0.2%, suggesting annualised rates just shy of 2.5% and getting comfortably close to the Fed’s 2% CPI target. Going out to 2 decimal places, the monthly increase in the core rate was only 0.15%, the fall driven by an 8.1% decline in airline fares alongside more modest reductions in hotel room rates (down 2.0%) and used car prices (down 0.5%). Importantly, used car prices in particular are expected to continue falling over H2 as the surge in auction prices caused by elevated rental fleet demand seen over the winter period continues to reverse. These falls take a few months to appear in the CPI calculation, suggesting that June will be the first in a series of monthly declines. The Fed’s current favoured CPI measure, core services ex-rent, rose at an annualised rate of 2.9% over Q2. This is obviously still too fast but is a considerable slowdown on the equivalent Q1 reading of 4.8% and, importantly, should also continue to ease going forward.
However, despite these softer numbers, they are probably unlikely in themselves to dissuade the Fed from hiking rates again this month; indeed the FOMC could easily view a further 25bps rise as an insurance measure to ensure monetary policy maintains its downwards momentum on inflationary pressures. This is particularly pertinent given that much of today’s falls can be attributed to base effects, suggesting that we will not see such large reductions in the CPI numbers over H2. But this caveat aside, the figures will see market expectations rise that July’s move could be the last hike in the current cycle and that we are closer to an easing in policy than expected hitherto. Indeed, if core inflation continues to decline going forwards as expected then the FOMC will find it increasingly difficult to justify to both the public and the markets as to why rates might need to be raised again, particularly if it is serious about trying to avoid a ‘hard landing’. And especially so if the labour market, as evidenced by payrolls growth, continues to soften as we expect.
Certainly the markets are no longer expecting a second hike to be delivered in September. While a July increase continues to be seen as certain, the probability of rates being hiked further in September is now seen at just over 15%, down from around 25% yesterday. The prospects of the first cut being delivered before end-year has also risen, from 19% to 22%, while two-year yields are down around 12bps and the US dollar is similarly trading on a softer footing. Tomorrow we get the PPI numbers, where the markets will be expecting to see further evidence that inflationary pressures are dissipating, an outcome that will keep both short-term yields and the US dollar trading on the back foot.