The markets have turned treacherous again after a brief bounce the last couple weeks. As we have noted over the years, there are times the markets become like a toddler – they can focus on only one thing at a time. Now it’s all about inflation. How high is it going? For how long? And what will the authorities do to fight it (if anything)?
On Friday we got another hot consumer price inflation (CPI) report. Headline CPI rose 8.6% YoY, well ahead of the 8.3% economists projected (figure below). Core prices rose 6%, also more than anticipated.
As the chart above starkly displays, the last time inflation was this hot the Fed Funds rate was at 13%. This time it’s below 1%.
Probably what unnerved investors more than the actual inflation number was the fact that the month-over-month comparison was higher. As you can see below, the rate in May was up versus April, obviously with energy and food playing a big role. Nothing transitory to be seen in this report.
We are all familiar with the energy story (more in the charts section below for the masochists among you). But food inflation is proving to be just as important. The chart below highlights how much food prices are up over the last few months. ‘Food at home’ prices jumped 1.4% in May, the fifth consecutive monthly gain of 1% or more. On a 12-month basis, grocery prices rose almost 12%, the most since 1979.
What this all means for policy is pretty clear. The Fed will conclude their two-day meeting next Wednesday and a half-point hike is all but assured. Could they go 75bps? It’s certainly possible, but most think the Fed will avoid surprising the markets and instead set the stage for half-point hikes in July and September. But is Powell nearing his Volker moment?
How Will the Economy React to Higher Rates?
The market is now pricing in a Fed Funds rate at over 3% by year-end, as you can see below.
Whether we get there or not will depend on the trajectory of economic growth in the near future. There are growing signs that 2nd quarter growth will be soft. And this comes on the heels of a contraction in the 1st quarter. For example, jobless claims ticked higher again this week.
And anecdotally, we are hearing about far more hiring freezes and layoffs, especially in the beleaguered tech sector.
Consumer spending might also be slowing. Target has come out twice in the last month saying demand is down and inventories of unsold goods are surging. This is true at the macro level as well, although it’s not clear if it’s due to lower demand or healing in supply chains.
For the markets, the sole focus in the second half is likely to be on whether inflation will moderate as growth slows, or will the Fed be forced to take greater and greater risks with recession to cool both demand and prices.
Europe is in Another Bind
Europe is also battling an inflation problem, and this week their central bank openly acknowledged the issue. At their meeting the ECB set the stage for a rate hike at their next meeting in July, and they also raised the prospect of a bigger half-point shift in September.
The bank last raised rates in 2011 and its deposit rate (equivalent of our Fed Funds rate) now stands at minus -0.5%. Yes, it’s still negative while inflation is running at 8% (chart below). And you think the Fed is disconnected from reality!!!
While inflation in the U.S. is pretty broad based, in Europe it is tied much more closely to oil and natural gas prices. I came across an interesting chart this week that shows oil prices denominated in dollars, euros, and pounds. You can clearly see that oil in euros and pounds is well above all-time highs due to the strong dollar/weak euro and pound.
As the ECB raises rates and ends their bond purchases, the chart below will bear watching. Can the Italian, Spanish, and Portuguese bond markets stand on their own, or are spreads going to blowout again in the months to come? Time will tell.
Charts We Found Interesting
1. It is striking how much oil on a per capita basis Canada and the U.S. use.
2. Not exactly running out of oil, but the reserves are getting low.
3. So much for the Strategic Petroleum Reserve releases helping cap prices. And at some point this will need to be filled again.
4. Apparently cypto hasn’t been the inflation hedge it was touted to be. Total cryptocurrency market capitalization, including stable coins and tokens, has now declined ~$1.8 trillion from the November market high.
5. Canadian housing prices are in a league of their own!!
6. The Russian Ruble has recouped all its losses from the Ukraine invasion, and then some (higher line = weaker Ruble).
Have a good weekend.
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