Digital Zeitgeist – Cooling US CPI Supports Case for Fed’s Pause in Monetary Tightening
The United States economy in May painted a picture of moderate consumer price inflation, marking the smallest annual increase in over two years. While underlying price pressures remain potent, these new figures boost the argument that the Federal Reserve should maintain its current interest rates, balancing hawkish sentiments with a pause in monetary tightening.
According to the Labor Department, the Consumer Price Index (CPI) rose by a mere 0.1% last month, as gasoline prices experienced a dip. This contrasts with a 0.4% increase in April. Over a 12-month span ending in April, the CPI escalated by 4.0%, the smallest year-on-year increase since March 2021, and less than the preceding month’s 4.9% increase. Predictions by economists, as surveyed by Reuters, had anticipated a 0.2% rise in the CPI and a year-on-year increase of 4.1%.
Market reactions were immediately visible. Futures connected to the Federal Reserve’s policy rate dropped post-data release, as traders solidified expectations that the central bank would forego a successive 11th interest rate hike and maintain the benchmark rate between 5.00% and 5.25%.
Repercussions in the financial market indicated a similar tone. U.S. stock index futures inched up slightly, standing at a last recorded increase of 0.33%, signalling a robust Wall Street opening. On the other hand, U.S. Treasury yields fell, with the 2-year note settling at 4.51%, and the 10-year note at 3.697%. Simultaneously, the euro extended to a 0.52% gain against the U.S. dollar, and the dollar index weakened by 0.444%.
Stuart Cole, Chief Macro Economist at Equiti Capital in London, echoed this sentiment. He observed, “The expected softening in US CPI has materialised, with both the core and headline monthly readings printing in line with expectations.” Cole added that the steep fall in the annual headline rate meant annual price increases were now expanding at their slowest pace since March 2021. He further noted that these figures were likely sufficient for the Federal Reserve to hold interest rates for the current month.
However, a closer inspection of the situation suggests two interesting narratives. Firstly, the Bureau of Labor Statistics (BLS) indicated that shelter costs, chiefly rents, were the largest contributing factor to the 0.1% increase in the headline monthly reading. These shelter costs, representing the most significant services component of the CPI, largely surrendered the gains made in the post-COVID phase.
Secondly, juxtaposing the above is the fact that the core monthly rate remained steady at 0.4%, a figure that stands too high to comply with a 2% inflation target, underscored by the relatively more modest fall in the annual core inflation rate.
Other experts in the field like Joseph Lavorgna, Chief U.S. Economist at SMBC Nikko Securities in New York, and Peter Garnry, Head of Equity Strategy at Saxo Bank in Denmark, provide further insight into this situation, reinforcing the general consensus that the Federal Reserve will indeed maintain the benchmark rate.
Looking at it from a neutral perspective, some could argue that the moderate rise in the CPI might indicate a slowing economy and a potential risk of deflation, but the consensus seems to be that the Fed’s pause in rate hikes is the appropriate response. Some may also express concerns about the overvaluation of assets, particularly stocks, given the current low-interest-rate environment. These divergent views only underscore the complexity and uncertainty of monetary policy management.
Taking a Devil’s Advocate View
Economics is often compared to meteorology: the tools available can provide a reasonably accurate forecast, but they can also be spectacularly wrong. It is essential, therefore, to challenge any prevailing views critically.
In the current scenario, a key counter-argument is that although the CPI report was weaker than anticipated, it still represented a significant 4.0% year-on-year increase in prices. Core inflation, which excludes volatile food and energy prices, is stuck at a relatively high 0.4% monthly growth. Despite the slowdown, this figure is not compatible with the Federal Reserve’s 2% inflation target, which might justify another 25 basis points rise in interest rates.
Moreover, the market’s expectation that the Fed will forgo an interest-rate hike in June, despite pricing in an 80% chance of an increase in July, presents an interesting quandary. If a further tightening of policy is indeed necessary, it might make sense to implement it now rather than postponing the inevitable.
Additionally, the impact of shelter costs on CPI cannot be ignored. While the Bureau of Labor Statistics reports that they were the largest contributor to the moderate increase in CPI in May, the delayed impact of rent movements on CPI means that more downward pressure is yet to materialise. While this supports the notion that inflationary pressures are moving in the right direction, it also hints at a more complex picture beneath the surface.
The future path of interest rates will also be dictated by factors other than inflation. The Fed may be pushed to continue hiking rates if the labour market remains tight or if there is a reacceleration of broad GDP trends. The possibility of an unexpected economic event or crisis also can’t be ruled out.
Then there is the ‘animal spirits’ effect mentioned by Peter Garnry. The over-exuberance seen in equity markets could pose a significant risk, particularly if it’s fuelled by speculation rather than fundamentals.
In conclusion, while the latest CPI data is supportive of the argument for a pause in rate hikes by the Federal Reserve, the complexities and interdependencies within the economy mean that the debate is far from settled. Only time will tell whether the inflation genie has been put back in the bottle or whether it’s merely taking a breather. The Federal Reserve, along with market watchers around the world, will be keeping a keen eye on the data over the coming months.
Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of GPM-Invest or any other organisations mentioned. The information provided is based on contemporary sourced digital content and does not constitute financial or investment advice. Readers are encouraged to conduct further research and analysis before making any investment decisions.