In April, US inflation exceeded market expectations at 8.3% YoY. The rise was driven by increasing food prices and core CPI (Consumer Price Index) while energy prices declined. The Core CPI spiked at 6.3% YoY (Source: Bloomberg). It was driven by a surge in airfares, a volatile category, strong prints for Shelter, the most important of the eight components of the index, and new vehicle inflation; used-car deflation slowed.
Just a few days after April CPI data were published, Fed Chair Powell said, “Inflation is just way too high. I’m gonna go with what I really am thinking is, get inflation back under control.”
Since March, the Fed has already raised interest rates by 75 basis points (bps) to 0,75%-1% (Source: Bloomberg). The Federal Open Market Committee (FOMC) is signaling for at least two rate hikes by half a percentage point at each of its next policy meetings in June and July. Fed officials have indicated that additional rate hikes are likely beyond the long-term nominal neutral rate (2.40%) without a pause. During the FOMC press conference on May 4, Chair Powell downplayed the importance of the neutral rate, noting, “So it’s a concept really. It’s not something we can identify with any precision. So, we estimate it within broad bands of uncertainty.”
The Fed’s policy stance will depend on how the US economy is able to withstand tighter financial conditions. In the near term, we expect Fed rhetoric to remain very hawkish. The central bank chief recently told the Wall Street Journal, “We need to see inflation coming down in a convincing way. Until we do, we’ll keep going. If that involves moving past broadly understood levels of neutral, we won’t hesitate to do that.”
Inflation may now have passed the peak. The April print fell below the March high of 8.5% YoY and the softer-than expected Producer Price Index (PPI) reinforces this view. The Dallas Trimmed Mean PCE (Personal Consumption Expenditures) Inflation Rate, which excludes the wildest price swings each month and averages the remaining price changes, is encouraging. One-month Trimmed Mean PCE Inflation slowed to a 3.1% annual pace from the 4.0% jump witnessed in February. The measure suggests inflation peaked in January, when the Trimmed Mean PCE Inflation Rate hit a one-month annual rate of 6.3%. (Source: Bloomberg)
Regardless, the Fed’s message to financial markets is very explicit for now. The central bank will continue to prioritize the fight against high inflation over future growth concerns.
At the start of the second quarter, harder economic data paints a more optimistic picture than the soft economic indicators. In April, manufacturing production posted solid gains for three consecutive months. In addition, the rising capacity utilization rate might be indicating that supply chain disruptions are declining. Despite the erosion in purchasing power from higher inflation and recent softening in consumer sentiment, retail sales rose strongly in April, increasing for the fourth consecutive month.
What are the consequences for financial markets?
Overall, markets are still digesting the tightening of financial conditions. The US expected real inflation rate over a five-year period, beginning five years from now has increased considerably since January 2022; up by almost 100 bps, from around -0.40% to 0.37%. However, the 5-year, 5-year forward inflation expectation rate it is still 70 bps below its 2018 peak. (Source: Bloomberg)
Fears of hawkish central banks in developed markets (i.e., interest rates hikes into restrictive territory) and elevated recession risk in 2023-2024 are indicative of a very negative environment for risky asset.
How are markets pricing a recession risk?
According to J.P. Morgan Research, US and Euro area equity markets are pricing in a 70% probability of a near-term recession, compared to a 50% probability in Investment Grade credit, a 30% probability in High Yield and a 10%-20% probability in money markets. We would be more cautious than J.P. Morgan. Inflation will strongly impact consumer demand, especially in Europe, and central banks will continue to tighten monetary policies as long as inflation is not showing signs of cooling off. This is not the best environment for risky assets over the medium term even If there is some short-term relief.