CPI inflation has finally passed its peak, and we’ll surely find out on Wednesday morning. Lower gas prices, retail discounting, the return of online deflation, and lower freight costs suggest there will be a very rapid decline from the 9.1% inflation rate in 40 years in June.
The combination of peak inflation and a retreat from the Fed’s peak peak was an antidote to the bear market. After sharp gains since mid-June, the Dow Jones and S&P 500 indexes jumped out of bear market territory. Only the Nasdaq’s loss still exceeds the 20% bear market threshold.
But Friday’s strong jobs report capped the upside. Could low inflation give it a fresh boost?
CPI inflation forecast
Wall Street economists expect the CPI to rise 0.2% in July, after rising 1.3% in June. The annual inflation rate is expected to decline to 8.7% from 9.1%.
However, core inflation, which excludes food and energy prices, is not expected to show much moderation. Core CPI is expected to rise 0.5% month over month, after rising 0.7% in June. Core inflation is expected to rise to 6.1% from 5.9%, with rising shelter costs as a major contributor.
Inflation rate forecast
However, not only the headline inflation rate falls, but also inflation expectations. The New York Federal Reserve’s survey of consumer expectations released on Monday showed that the median expectation for inflation three years from now fell to 3.2% from 3.6% the previous month. Five-year inflation expectations eased to 2.3% from 2.8%.
The reason that matters to policy makers is that inflation looks at consumer psychology, influences shopping behavior and even bargaining for higher wages. The more inflation takes hold, the more difficult it will be to uproot the Fed.
With signs that consumers are becoming less concerned about the prospect of permanently high inflation, the Fed will feel less need to rush into raising interest rates.
No more forward guidance from the Fed
Already, Federal Reserve Chairman Jerome Powell said on July 27 that policy makers have put forward guidance on hold. They will go to meeting after meeting, and decide the appropriate policy setting based on the latest data. What has changed? As the Fed’s key interest rate approaches the neutral level and heads towards the restricted area, policy makers tend to move more gradually. This is particularly the case because signs of economic weakness have spread from housing to consumer spending to business fixed investment.
Next Fed rate hike: 50 or 75 basis points?
Currently, Wall Street sees 67.5% odds of a rate hike of another 75 basis points when the Fed adjusts its policy on Sept. 21. Those odds were amplified after Friday’s unexpectedly hot jobs report.
Here’s the good news: the odds of a bigger move may be overstated.
Jeffreys chief financial economist Anita Markowska wrote that the decision to raise 75 basis points at each of the two previous Fed meetings “was driven by rising inflation expectations, which have since declined decisively.”
In addition, a second weak CPI report is due before the Fed meeting in mid-September. At this point, Markowska sees August prices could contract 0.2% vs. July amid a further decline in energy prices.
The Fed’s focus shifted to core inflation
When oil prices were still rising, Powell seemed to downplay the Fed’s usual focus on core prices, saying the concept was unfamiliar to households struggling with inflation.
Now that oil prices are down, Powell is once again focused on core inflation. “Core inflation is a better indicator of future inflation,” Powell said at his press conference on July 27.
“Commodity inflation should also subside in the coming months given compelling evidence that supply chain stresses are easing,” Markowska wrote. But it expects basic services inflation to “remain flat, buoyed by tightness in the housing and labor markets”.
Non-energy services, or essential services, account for 57% of consumer budgets, according to the Department of Labor, led by Housing and Medicare. Inflation in these categories was 5.5% in June, the highest level in 30 years.
Recession atmosphere deepens for the US economy: IBD / TIPP
Two economic tracks report after jobs
Dow Jones’ initial reaction to the July jobs report was muted, in part because markets were looking forward to this week’s weak CPI inflation data. However, in its wake, the hopeful pivot for the Fed seems far away. What is clear from the report is that the job market is as tight as a drum. If employment is really as strong as the reported gain of 528,000 jobs, then the Fed is off.
Deutsche Bank economists say the jobs numbers “reinforce our above-agreed call for a 4.1% fed funds rate, which the market now appears to be waking up to.”
Another possibility is that the jobs data exaggerate the strength of the labor market. The Department of Labor’s household survey shows that the number of employed people has fallen by 168,000 over the past four months, even as the employer’s survey showed 1.68 million new jobs.
But even if the labor market is weaker than it appears, there is no reason to doubt that the jobs report indicates that the labor market is too tight. If so, wage pressures and core inflation may fade more slowly. The Fed may stop tightening soon, but it could take some time to focus on lowering interest rates and ending balance sheet tightening.
Dow Jones on hold?
After Friday’s jobs report, financial markets are pricing in a quarter-point rate hike to a range of 3.5%-3.75% by early next year. By the middle of 2023, the prospects for the financial market are tilting toward an easier policy. But the high Fed funds rate makes the path to an easy landing even more difficult. It indicates higher odds that the Fed will overshoot, causing a recession and a dip in earnings.
On Tuesday, the Dow was down 0.2% and the Standard & Poor’s was down 0.4%. Nasdaq, which has outperformed in recent weeks, returned 1.2%.
Having already made a solid rally, it may take some soft core inflation readings to reignite the bulls.
You may also like:
New Stock Repurchase Tax: What It Means for Apple and the S&P 500
Best growth stocks to buy and watch
Join IBD Live and learn the best chart reading and trading techniques from professionals
How to make money from stocks in 3 simple steps
Intermittent selling surges in the market with inflation data due