To read some of the headlines that followed yesterday’s release of the Consumer Price Index (CPI) report for the month of June, you would think that everything in the economic garden is now rosy, with inflation just a speck in our rearview mirror. They highlighted the fact that the index itself increased at a rate that represents only 3.0 percent annual inflation, the lowest rate since early 2021. Those headlines are factual, but if you read a little deeper into those articles, and into the report itself, things look a bit less clear. That makes the very positive, and sustained, market reaction a bit puzzling.
Much of the drop in the inflation rate was due to changes in the normally volatile food and energy prices and, when they were stripped out, core CPI rose 4.8 percent on an annual basis. To most of us, for whom food and energy make up a big part of our expenditure, that doesn’t really matter that much as we still would have had more money in our pockets once the essentials were paid for. For the Fed, however, the 4.8 percent core inflation rate matters more than the 3 percent headline rate, and 4.8 percent is still a long way from their stated target of 2 percent.
The gains in the major indices yesterday were more about the market looking for positives than about any objective analysis of the whole report. The Fed has pretty much told us that they will raise rates again this month, but traders clearly believe now that that will be the last hike in this cycle and are looking ahead to a reversal of policy before too long. The problem, though, is that the Fed has said repeatedly that headline CPI is not their preferred measure of inflation. They prefer to look at Core Personal Consumption Expenditure (PCE), which will be released at the end of the month. That indicator has shown increases of 4.6 or 4.7 percent in each of the last five months and it would take a big drop this month for it to really signal an end to what Jay Powell sees as worrying inflation.
What traders are betting on, it seems, is that the Fed will shift their focus, ignoring core PCE and looking instead at the underlying inflationary pressure, and there the news is really good. The Producer Price Index (PPI) that came out this morning showed a less than expected 0.1 percent annual increase, indicating further falls in CPI over the next few months, and even though food and energy are omitted from core numbers, they do influence that underlying pressure. The question is, will the Fed, having consistently said that they are following one data point, now abandon that and look at a broader picture?
If they do, there is other news outside the U.S. that would suggest that a much more dovish approach is warranted. Chinese exports slowed dramatically last month, which points to the possibility of a dramatic slowdown in the rest of the world. While that is not a direct concern for the Fed, if they are taking a more holistic view, it is certainly something to consider. They don’t want to be hiking rates into a global recession. Still, everything hangs on how flexible the Fed will be and, as a rule, flexibility is not something for which central bankers are known.
As for what is next, there is no reason the positivity that has pushed stocks so much higher already this year will end. Despite the signs of global problems, there is now a good chance that the market will once again be right, and that the U.S. economy can be guided to a soft landing with inflation coming under control without any major pain. What this does do, though, is to make the upcoming FOMC meeting that will be held in two weeks, and what they say following it, of vital importance.
The market is now understandably convinced that the FOMC members will be forced to signal an immediate end to rate hikes, but that is being priced in rapidly, so any hint that they are instead sticking to their original plan to rely on core PCE could cause a rapid turnaround. With traders taking only the good news from the CPI and PPI reports into consideration, further gains can be expected. However, investors should keep a wary eye on things, because there are a lot of assumptions behind this bullishness, making the rally fragile, no matter how strong.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
Martin Tillier
Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.
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