Inflation comes in below expectations

We have just seen the latest US inflation update in the form of the Consumer Price Index (CPI). The consensus expectation was for an increase of 7.9% year-on-year for Headline CPI. To everyone’s astonishment it came in lower at +7.7%. Core CPI, which excludes food and energy, also came in below expectations at +6.3% year-on-year, against a forecast of +6.6%. In addition, the month-on-month data showed signs of slowing, which was a relief given recent gains. This was exceptionally good news for investors as inflation, with just one exception this summer, has come in above expectations since the beginning of this year. Now it looks as if we can confirm that Headline CPI peaked, for this cycle, back in July at 9.1%. Bear in mind, the US Federal Reserve was very late in its response to surging inflation, raising rates by just 25 basis points in March this year. At that time inflation was running at 7.9%, up from 1.7% 12 twelve months previously. Since then, the Fed has raised rates by an additional 350 basis points, taking the upper range of its key Fed Funds rate to 4.0%, its highest level since December 2007. In addition, the futures market assigned a 50% chance of another 75-basis point hike this December, although that dropped to less than 20% following the latest inflation data.

Risk on

The market reaction was swift and dramatic. Stock indices flew higher. The S&P 500 added 100 points within the first minute of the release. There were also big gains for precious metals and government bonds while the US dollar dropped sharply. Many traders thought this reaction was overdone. But US stock indices built on their early advances and pushed higher over the next couple of hours. The big questions are: can we be confident that we’ve seen inflation peak, and how will the Federal Reserve react?

Comparisons

There’s little doubt that the year-on-year comparisons should flatter the data in terms of inflation growth. Headline inflation was 6.2% in November last year, rising to 7.9% in March before peaking in August. That means we should expect the year-on-year numbers to fall. Therefore, the month-on-month data should be the focus going forward. The Federal Reserve’s response should be interesting. The better-than-expected CPI data came just one week after the US central bank raised rates by 75 basis points for the fourth meeting in succession. In addition, Fed Chair Jerome Powell was notably hawkish during his subsequent press conference, dismissing suggestions of a pivot away from tightening monetary policy, and stating that existing predictions over the ‘terminal’ rate for Fed Funds were too low. Following this latest update, he won’t want to switch suddenly into reverse gear, but it’s likely that other Fed members will start to sound more dovish, particularly if unemployment starts to rise. Fortunately, the Fed’s monetary policy statement included some dovish comments. The FOMC (Federal Open Market Committee) said it would consider the cumulative effects of rate hikes. Given that rates have now risen to 4.0% from under 0.25% in just 8 months, that implied that smaller rate hikes, or even a pause, could now be expected. This view was reinforced by the FOMC stating that rate hikes act with a lag, and that they would be taking economic and financial developments into account. Again, with most market participants expecting an economic slowdown, and with unemployment near record pre-pandemic lows, it seems reasonable to expect weaker economic data in the future, giving the Fed reason to temper their aggressive monetary tightening. Many will now be wondering if this will provide a tailwind for equities, helping them to make back some of their losses going into year-end.