The Big Picture
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Last Updated: 10-Aug-22 17:45 ET | Archive
Peak inflation? Maybe. Peak hawkishness? Not yet.
Some dates are more important than others. What we know following the July Consumer Price Index (CPI) is that September 2 and September 13 just became more important.
Step by Step
September 2 is the date on which the August Employment Situation Report will be released and September 13 is the date on which the August Consumer Price Index will be released. Both reports precede the next FOMC meeting, which is scheduled for September 20-21.
Briefly, the market got good news in the July CPI report. Total CPI was unchanged, aided by a drop in energy prices, and was up 8.5% year-over-year versus 9.1% in June. Core CPI, which excludes food and energy, increased 0.3% and was up 5.9% year-over-year, unchanged from June.
There was improvement in the overall trend, but, objectively, there was no improvement in the core rate of inflation versus June. That was okay for the market, however, because no change was still better than an uptick. No change at least supported the narrative that we might have seen peak inflation.
What market participants cannot be sure of is that it means the Fed will take a smaller step at its September meeting, raising the target range for the fed funds rate by 50 basis points instead of 75 basis points.
The fed funds futures market is anticipating a smaller step. Prior to the release of the July CPI report, the fed funds futures market was assigning a 32% probability to a 50-basis point rate hike and a 68.0% probability to a 75-basis point rate hike, according to the CME Fed Watch Tool. Those expectations reversed after the July CPI report. Now, the probability of a 50-basis point rate hike sits at 62.5% while the probability of a 75-basis point rate hike has fallen to 37.5%.
That was a hyper-reflexive response to a report that seemingly contained good inflation news. It did in some respects, but not all respects. Moreover, the July report was just one report, and if Fed officials are to be believed, they need to see more than just a single report to be convinced that they can take a smaller step.
That's probably why the Treasury market faded after a wave of knee-jerk buying interest came in following the July CPI report. The latter helped temper the concerns about a bigger rate-hike step that were inflamed by the July employment report, which featured a 528,000 increase in nonfarm payrolls and a 0.5% increase in average hourly earnings.
The 2-yr note yield dropped from 3.27% to 3.08% in an instant. The 10-yr note yield fell from 2.80% to 2.69%. The 2-yr note yield and the 10-yr note yield eventually reverted to 3.19% and 2.79%, respectively.
Hence, the August employment and CPI reports just became more important. They are destined to be swing factors in the decision between a 50-basis point rate hike or a 75-basis point rate hike.
The "Ex" Factor
In other words, the July CPI report did not settle anything -- and why would it? Inflation is still well above the Fed's 2% target, and, just to reiterate, there was no improvement in the core rate of inflation.
Furthermore, what we call the "ex" factor in measuring inflation rates remains abnormally high on all fronts. To wit:
- All items, ex food was up 8.1%
- All items, ex shelter was up 9.9%
- All items, ex food and shelter were up 9.7%
- All items, ex food, shelter, and energy were up 6.1%
- All items, ex food, shelter, energy, and used cars and trucks were up 6.0%
- All items, ex medical care was up 8.9%
- All items, ex energy was up 6.6%
Things could have been worse, so it was a relief that they were not. Still, the inflation rate, measured overall, or by any "ex" factor, shows more medicine needs to be administered before there is an inflation cure.
Minneapolis Fed President Neel Kashkari (2023 FOMC voter), who garnered the label of being the biggest dove before the Fed started to raise rates, told CNBC after the July CPI report that the Fed is "far, far, far away" from declaring victory on inflation and that he thinks the terminal rate is 3.9%. The target range for the fed funds rate is currently 2.25-2.50%.
The debate will rage on as to the proper dosage, which means Treasuries are apt to remain volatile in response to that debate, not to mention the bigger step that will be made with quantitative tightening, starting in September.
The Fed's job did not get any easier with the July CPI report. If anything, it got more complicated. That raises the stakes for a potential policy mistake being made (i.e., not doing enough and letting inflation fester at unacceptably high levels or doing too much and driving the economy into a recession).
What It All Means
The market had cast a nervous eye toward the July employment report and the July CPI report. The former was stronger than expected while the latter was weaker than expected. The stock market certainly had a sparkle in its eye after the CPI report; the Treasury market had a speck in its eye; and the Fed, well, it is likely feeling cross-eyed given the disparate nature of the reports.
Accordingly, Fed officials will have their eyes trained on the calendar. September 2 and September 13 are the presumed settlement dates that will drive either a smaller policy step or bigger policy step at the September FOMC meeting.
As it stands now, nothing is settled. The rate of change in overall inflation might be cooling off, which is welcome news, but at 8.5% year-over-year, that still won't foster a sigh of relief on Main Street like it did on Wall Street. Also, there was no improvement in the core rate of inflation versus June and the core rate is where the Fed's attention is focused.
Peak inflation might be all the talk after the July CPI report, but without the benefit of seeing the employment and CPI reports for August, it is premature to put peak hawkishness in the same conversation.
-- Patrick J. O'Hare, Briefing.com
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