Weekly Market Perspectives: Stubborn inflation keeps Fed on edge
Published: September 18, 2023
Inflation and consumer health took the headlines this week with several reports on prices front-and-center for the markets. Following mixed inflation prints and retail sales figures showing the toll of higher prices, markets failed to find meaningful direction one way or the other. Investors were initially optimistic looking through the reports and pushed the probability of another 2023 rate hike lower ahead of the Federal Reserve’s meeting next week, but the market finished modestly lower following poor sentiment figures released on Friday. The S&P 500 ended the week down -0.1% and the US Aggregate index was lower by -0.3% as interest rates continue to exhibit upward pressure. The US Aggregate bond index has now given back -1.8% in Q3 and only sits +0.3% for 2023 as rates continue to be the dominant theme of the year.
Headline and core inflation reports from the Bureau of Labor Statistics on Wednesday came in just above expectations, but the month-over-month acceleration likely keeps the Fed on edge in their fight against rising prices. The core consumer price index, which excludes food and energy, advanced +0.3% from July, the first acceleration in six months while the headline CPI print showed an increase of +0.6% month-over-month, the largest increase since June 2022. The year-over-year figure for headline CPI increased to 3.7%, above consensus expectations and +0.2% higher than the July figure. While the rise in headline CPI was not entirely unexpected with benign readings from 2022 rolling out of the calculation, it was price increases in energy and gas that proved decisive last month. The Fed could be willing to look through the volatile energy inputs, but it is sticky services pricing in transportation and housing that will maintain higher pressure on rates. The report suggests the Fed will keep their options (and rhetoric) open at the upcoming meeting even though investors are not expecting any change in the Fed Funds rate next week. However, with the recent reports showing higher consumer and producer prices, the probability of another rate hike before year end refuses to go away.
Investors will have a close eye on the Fed dot plot projections – or the expected policy rate among FOMC members – as policymakers are likely to suggest one more rate hike in 2023 and a higher terminal (or long-term) rate even if the market refuses to believe it. This has been a consistent theme throughout the Fed rate hiking campaign where the Fed has consistently led the market’s expectations higher only for the market to adjust to the Fed’s view, not the other way around. There is some optimism though as economic data (namely inflation) is trending in a direction that should suggest the end of rate hikes is near. Fundamentally, the higher long-term rate expectations are inclusive of more robust economic activity, higher base prices, and a resilient labor market. These are mostly positive developments for the broader economy, but the rising interest rate expectations across the curve have proven to be a headwind for the capital markets.
A resilient US economy likely keeps interest rates at the current level, if not higher, for the foreseeable future according to a Bloomberg survey of economists. The first cut expected by economists is now in May, two months later than the last survey suggested. The market mainly agrees – implied interest rate probabilities suggest the first full rate cut will now be in June 2024.
The Fed’s 2% target is proving difficult to achieve and will likely keep the Fed in a hawkish position. Fed Chair Jerome Powell warned that inflation remained too high and central bankers were prepared to tighten at the recent conference in Jackson Hole. It seems that recent economic data will keep the bias towards rates higher particularly with the Fed’s preferred measure of inflation, the personal consumption deflator (or PCE), remaining above 4%.
Producer prices and retail sales both jumped in August driven by higher fuel costs. Coupled with higher inflation in August, real retail sales figures were pushed back into negative territory highlighting the weight of rising prices on household spending.
On Friday, University of Michigan released survey results showing US inflation expectations fell to the lowest level in more than two years as consumers see signs of slowing economic activity. Consumers now expect the annual rate of inflation near 3.1%, down from 3.5% in August, and see long-term inflation figures near 2.7%, matching the lowest readings since the end of 2020. The latest sentiment report is likely welcomed by the Fed as consumer expectations for inflation can have meaningful impact on spending behavior. Additionally, general consumer sentiment fell again weighed down by rising food and gas costs.
Source: Bloomberg, BLS, Federal Reserve