Premature Extrapolation

TUE 08 AUG 2022

Sometimes the most obvious interpretation is the correct one. The July US CPI was lower than expectations on the headline and core measure leading to a rally in risk assets and a re-calibration of short term interest rate expectations. As we often ask; what is our quarrel with price? One month of lower-than-anticipated inflation is a good start toward conquering inflation, but unlikely to convince the FOMC that the trend has turned. Indeed, the interpretation by some analysts that the Fed will pivot at 8.5% inflation seem heroic at best. Put another way, the Fed will likely require further evidence of a meaningful deceleration in consumer prices before adjusting the current path of monetary policy.

Beyond the good news of the downside surprise on headline and core (ex food and energy) the shelter component (which is the largest monthly cost for most Americans) moderated from 0.6% to 0.5% in July. However, that pace of increase is still unacceptably high. Shelter costs also tend to lag and remain sticky relative to other components and will likely remain elevated for several months despite the moderation in leading indicators. The big picture point here is that the Fed will likely err on the side of vigilance rather than premature relaxation of short term interest rate expectations and financial conditions.

The second point to note was that inflation breadth remains uncomfortably high. As we noted recently, that is evident in the Cleveland Fed’s trimmed mean measure of inflation (chart 1) which increased further on a year over year basis in July. The trimmed mean is arguably a more accurate reflection of core inflation relative to the exclusion of the same core items (food and energy) every month. It is the key measure of core inflation for the Reserve Bank of Australia for that reason. To reinforce the point above, the Fed will observe the broader underlying trends beyond the current month and the windfall gain from lower gasoline prices in July.

An excellent point made by Cam Crise was the policy error made during the early 1980s. Back then, the Volcker Fed eased policy aggressively as the year on year inflation rates peaked and the economy tipped into recession. However, the moderation of price pressures proved much slower than the FOMC wanted and the Committee felt compelled to tighten again a few months later. Once again, the burden of proof in this episode is likely to be rather high, especially when nominal growth and unit labour costs remain elevated.

The final point to note is that a rally in financial assets or an easing in financial conditions would be counter-productive to the Fed’s goal to moderate inflation expectations. Moreover, the consequence of tighter financial conditions already achieved will ease inflation but it will also lead to a slowdown in final demand and corporate earnings. As we have reiterated over the past few months, that has not been fully discounted by equity markets (at an aggregate level). In summary, while the moderation in consumer price inflation in July was positive, it is heroic to expect the Fed to pivot at 8.5% inflation. Odds are the current counter trend rally will probably fade over the coming weeks.