The Federal Reserve (Fed) began a steady campaign of rate hikes in March 2022, when inflation was approaching its highest level in 4 decades.
Now, with more than 5 percentage points of hikes in the rearview mirror and a fed funds rate of 5.25%, the macro picture looks much healthier. The easing of inflation and an economy that is bending rather than breaking has allowed the market to embrace hopes of a “soft landing,” and although the latest headline August print tested that narrative, outside of energy prices the report was another positive step along the road to lower inflation. We see an ongoing decline in US inflation as key support for both equities and bonds over the coming year.
Energy Headwinds Signal Headline Choppiness ahead
The US consumer price index (CPI) release showed monthly inflation accelerated in August. While the increase in headline inflation from 0.2% month-on-month (MoM) to 0.6% MoM was in line with consensus estimates, the core index’s 0.28% MoM rise came in slightly above expectations, which were for it to remain unchanged at 0.2%.
In particular, the 10.6% monthly increase in gasoline prices accounted for over half of the increase in the headline index. This pushed the 12-month headline CPI rate up to 3.7%, from 3.2% through July and a recent low of 3.0% in June. Even with the reversal of the past couple of months, headline CPI inflation is down substantially from the peak reading of 9.1% in June 2022, and early data for September suggest a slight drop from that 3.7% next month.
Core Inflation Steadily Improving
Although core inflation unexpectedly accelerated, we still view the CPI release as evidence that the disinflationary trend is intact. The August print registered the third month in a row of sub-30 basis point (bp) increases with the 3-month annualised rate of core inflation now only 2.5% . The 12-month change fell from 4.7% in July to 4.3% in August, more than halfway back to its pre-pandemic pace, following the 6.6% peak last September.
While the August increase was 12 bps higher than the prior two months, the smaller monthly increases through June and July were unlikely to be sustained as they were held down by large declines in airfares and seasonal adjustment factors, which appeared overly sensitive to the large pandemic swings. In particular, airfares rose nearly 5% in August, after declines of 8% in both June and July. This swing in airfares contributed 9bp more to the core CPI increase in August than the prior month and resulted in the core services excluding the housing category increasing 37bp — its largest increase since March.
The stickiness in the core services component will be causing some concern for the Fed. However, emerging signs of the labour market gradually cooling (albeit from ultra-tight levels) and of the consumer balance sheet not being as robust as thought (excess savings are close to being run-down) support the idea that there is capacity for services inflation to come down further over the next year.
Rays of Light in the Recent Inflation Detail
Among other components, owners’ equivalent rent (OER), one of the more persistent CPI components, slowed notably to a 38bp increase in August, from 49bp in July, representing the smallest monthly increase in two years. Importantly, leading indicators of shelter inflation (rents on new leases reported by real estate platform Zillow) indicate that shelter inflation will continue to moderate. Indeed, the Zillow read-through suggests that the shelter component (which is 40% of the core basket) could ultimately take more than 1% off core CPI. A moderation in housing costs is an essential feature for a sustained downward trend in core inflation.
Pleasingly, core goods prices fell for the third month in a row. A significant contributor was the solid drop in prices for used vehicles (-1.2% MoM). Additionally, the majority of other core goods are also gradually converging towards their pre-pandemic pace. We expect core goods inflation will continue the downtrend that has been in place for some time now, given an unclogged supply chain and slower underlying goods demand. The closely watched Manheim Used Vehicle Index has also rolled over and foreshadows a decline in the used car component. This lead indicator suggests used car prices could drop about 6% in the coming month, contributing -16bp to the headline CPI change in September. This should be a welcome relief as the volatile gasoline component poses upside risk to the headline CPI print.
In recent months, the Fed has paid specific attention to the sleeve of inflation excluding food, energy and shelter. This is the so-called “super core” inflation measure. While stripping items out of the inflation index can be a dangerous game, in this case, there is good reason to believe both shelter and used vehicle inflation rates have significant downside in the coming months. As those prices ease, overall core inflation will settle near a much lower run rate.
However, the resurgence in energy prices cannot be completely ignored as increases filter into the prices of consumer products requiring transportation and services via airfares. These products and services are reflected in core CPI, which is how core CPI reacts indirectly to rising energy costs.
Also worth noting is the sensitivity of consumer inflation expectations to energy price fluctuations. This is in part due to consumers paying more attention to prices of more noticeable items such as petrol. While inflation expectations are currently well-anchored, rising expectations can create a self-reinforcing feedback loop, impacting actual inflation through increased wage demands and price-setting behavior.
When will the Central Bank Take its Foot off the Brakes?
While it may not be a straight-line process, we expect a further decline in US core inflation over the balance of the year and view the Fed’s tightening cycle as having reached its peak.
The Fed is expected to hold interest rates steady at this week’s Federal Open Market Committee (FOMC) meeting on September 20. Policy makers will disclose their short-term interest rate forecasts for the end of 2023 in this upcoming meeting, which should offer clues on a potential rate increase at the Fed’s subsequent November decision. The market currently assigns a 55% probability to rates remaining unchanged through the end of the year. Both the Fed and markets are forecasting that interest rates will remain generally elevated throughout 2024, with cuts only priced into the back half of the year.
In our view, “long and variable lags” are working through the economy, albeit slower than expected. The US labour market is softening from ultra-tight levels and the US consumer is now a fair way through their excess savings pool, so the potential for a significant weakening in US activity is building up behind the scenes. We should acknowledge that real income is also rising, partly offsetting said headwinds. We expect building evidence of slowing growth and cooling inflation to ease the recent upward pressure on bond yields. A slowdown to a soft landing remains our base case, and that should be a supportive backdrop for both equities and bonds.
We continue to hold our global equity allocation at a slight overweight as inflation risks ease and interest rate risks recede. We remain neutral Australian equities and hold a slight overweight to fixed interest, which should do well as growth and inflation both slow.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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