by Hubert Marleau, Market Economist, Palos Management
August 16, 2024
We are now in a world where investors are more and more focussed on the labour market, whereas the Fed’s obsession with defeating inflation is deemed less important. On the one hand, markets are pricing in for the September meeting, a 25 or 50 bps rate cut, while on the other, Fed speakers are becoming less guarded but still expressing no real urgency to pivot until more economic prints produce the confidence necessary for them to do so. Yet the NY Fed’s July Survey of Consumer Expectations showed the public outlook for inflation had fallen both significantly and confidently. Inflation expectations on the 3-year horizon were just 2.3%, the lowest since the series was inaugurated in 2013, registering a 0.6% m/m decline - , the largest ever. Accordingly, consumers are more or less siding with bond traders who are predicting that inflation will run below 2% over the next 3 years. Put simply, there's no sign that the 2022 inflationary episode remains embedded in psychology.
That brings us to Tuesday’s PPI numbers and Wednesday's CPI numbers, which produced upbeat news on both fronts, bolstering the case that both the public and the market are right about inflation.
July producer prices rose just 2.2% in the 12 months through July compared to 2.7% the previous month and up at a 3-month annualised rate of only 1.2%, despite a considerable rebound in gasoline prices. (As a matter of fact, only 24% of small business owners have indicated in a recent survey that they plan to raise prices, the lowest since April 2023.)
Meanwhile, July consumer prices fell to 2.9% y/y, at a 3-month annualised rate of 0.4%. The remaining elephant, of course, is shelter, accounting for 90% of the increase in the consumer price index. This, however, has a lot more to do with demographics than generalised inflation. Shelter cost is an economic price signal pointing to a lack of supply to house a growing cohort of singles, migrants, and young adults coming of age: a classic imbalance between supply and demand, which needs to be restored in part through higher prices to stimulate residential construction. Thus it shouldn't be a waiting game to see if and when shelter costs will fall.
Excluding shelter, headline and core inflation were only 1.8% and 1.7% y/y respectively. Bearing in mind that shelter cost represents a much large portion of the Consumer Price Index (CPI) than of the Personal Consumption Expenditure Price Deflator (PCED) - which happens to be the one gauge that Fed is enamoured of - the likelihood that the July PCED will fall below the June
2.5% y/y increase, when it will be reported on August 30, is very high, putting price rises within the Fed’s official target range (1% point either side of 2%). It’s not guaranteed, but is likely, since retailers are not only resisting raising prices, they are lowering them.
What is particularly encouraging about all this is that the process to lower inflation was not particularly alarming even though the shape of the yield curve and real cost of money made recession fears look rational. Indeed, most business and earnings prints have put those worries in practice on the back burner. As a matter of fact, the New York and Atlanta NowCasting economic models are not only tracking 1.8% to 2.4% economic growth for Q3, but contrary to other periods of economic expansion, this one has been accompanied by immaculate disinflation due to an unexpected surge in productivity. As a result, inflation has become a non-irritating issue, and the economy has once again turned into a normalising pattern.
This is a major breakthrough, explaining why consumer sentiment has risen lately. Little wonder why the stock market has been so resilient. In the week ended August 16, the S&P 500 closed at 5554, up 3.7%, registering the best week of 2024 and returning the VIX to where it was.
Nonetheless, while the latest data makes it clear that the economy is relatively healthy, the Fed is unlikely to veer off-course simply because it is now within the Fed’s target zone. Indeed, it may appear irrational, but the new focus will be on whether the risk of recession is rising. Several investment banks and reputable research organisations have recently raised this probability, even though the economic prints are hardly alarming. However, they are aware, as is the Fed, that a path of this nature is not permanently linear, particularly in a volatile and fragile world. According to a new indicator* that combines the unemployment rate with the vacancy rate, the number of unfilled positions relative to total jobs, both filled and still open, which is said to be more accurate than the Sahm rule in predicting recession, claims there is a 40 % chance that we are about to enter one. In this connection, a growing number of monetary officials who wish to maintain the soft landing believe that the Fed can ill afford to be too late with a rate cut, which just about everyone agrees that one is coming in September. In this regard, the CME FedWatch tool predicts that this rate cut is in the bag.
*Credit is given to economist Pascal Michaillat (U of C Santa Cruz) and Emmanuel Saez (U of C Berkeley) for introducing the new rule.
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