Weekly Market Perspectives: Sticky inflation may complicate soft landing
Published: August 11, 2023
Investors were pulled in several directions this week, but they generally remain captive to inflation data and the subsequent reaction from the Federal Reserve. Markets gave back some gains last week with the S&P 500 ending lower by -0.3% and the US Aggregate bond index traded down -0.6% as yields rose across the curve in reaction to inflation reports, Fed speak, and new debt issuance by the US Treasury.
The latest monthly report on US inflation confirmed expectations for a second straight month – rising prices have stabilized and showed a relatively tame increase in the cost of living. The +0.2% monthly increase for both the overall consumer price index (CPI) and the core CPI (ex. food and energy) in July showed price increases are running near a +2% annualized pace. The report was welcomed by investors initially, but it was not enough to ease fears that elevated inflation is going to be sticky for some time to come. The year-over-year reading of headline CPI – what consumers experience compared to prices one year ago – rose to 3.2%, up from 3.0% last month while the YoY core CPI number continues to trend lower, albeit slowly. If the Fed determines that 3%+ is still too high and core CPI shows few signs of returning to the long-term target, monetary policy will likely stay tight. Investors will be keeping a close eye on inflation and interest rates for the foreseeable future.
With annual inflation showing an increase over the latest report, there are reasons to believe inflation will stay in 3%-4% range for a while. First, the latest report was higher compared to last month largely due to a benign monthly reading in July 2022 falling out of the calculation. Going forward, more benign inflation months from 2022 are expected to roll off which will support higher readings for the year-over-year number. Moreover, the headline CPI reading has been benefitting from falling energy prices for the past several months, but this decline is expected to reverse as oil prices have been moving higher recently. Finally, producer prices (PPI) increased more than expected last month, driven higher by services prices, particularly in healthcare. Many view PPI as a leading indicator to CPI which may show increasing producer prices filtering through to consumer prices. With pressure building for higher inflation going forward, expect the Federal Reserve to keep interest rates at the current level for longer.
Another point of consideration is the resilience of demand. Should consumption remain robust, this will be another point supporting higher prices. As earnings season comes to a close, a few quarterly reports from consumer facing companies highlighted how spending has remained resilient, even in the face of prolonged price increases, while noting shifts in behavior as shoppers hunt for bargains (trading lower on quality or buying fewer goods). Companies have been able to sustain strong revenue and earnings on the basis of price growth (not volume). The data suggests that consumers are financing consumption with dwindling savings (from previous fiscal stimulus) and increasing use of credit card debt, over and above current earnings. This consumption pattern is not sustainable. We will get a different view on consumer health next week when retail sales figures are reported.
Services prices remain the most stubborn component of CPI compared to disinflation in most other segments.
Americans expect prices will climb at a 3.3% rate over the next year, down from the 3.4% expected in July, according to recent sentiment reports. This was a surprise given gasoline and food prices are increasing. Perhaps all the rhetoric around recession and the Fed’s fight against inflation is keeping consumer inflation expectations contained.
The market still expects the Fed to cut interest rates by over 1% over the next 12-14 months whereas Federal Reserve expects to keep rates higher than expectations. Regardless, it would seem the market and the Fed both expect rates to begin coming down in 2024.