The soft-landing narrative for the US economy assumes that a summertime string of comforting inflation data, both at the consumer and producer levels, opens the door even wider for the Federal Reserve to declare as early as next month the end to one of the most concentrated rate-raising cycles in decades. With that, the economy would avoid a recession, interest rates would fall in an orderly fashion, stocks would build on their already impressive gains, and highly levered corporate exposures would be normalized methodically.
Thursday’s headline-grabbing inflation data for July supports this reassuring storyline for the economy and markets. This is the case both at the overall level and at that of key individual components of the consumer price index, including core services. With that, traders have rushed to lower the implied probability of a Fed rate hike in September to below 10% and to increase the likelihood of rate cuts starting just a few months later.
There is certainly a lot to like in the latest CPI report. There is also a need, however, for greater care in simply extrapolating its path given some price developments in the pipeline.
Let’s start with the good news.
Consistent with the consensus forecasts, the CPI rose by 0.2% at both the headline and core levels in July. This took the annual measures of inflation to 3.2% and 4.7%, respectively. It supported the notion that the disinflationary process is well anchored, that further favorable news is coming down the road, and that this will enable the Fed both to refrain from increasing rates in September and to position itself for cuts early next year, if not before.
The qualification for this favorable narrative comes from what has been happening recently in commodities, which warrants monitoring. Absent a reversal of the notable increase in the prices of energy and certain foodstuffs in recent months, it’s just a matter of time until the pass-through effects are felt in the prices of a wider set of goods and services. At best, this would moderate what has been a strong disinflationary effect from the goods sector as a whole. At worse, it would result in a premature uptick in goods inflation that frustrates the much-anticipated disinflation in the services sector.
If this materializes — and that’s still a big question — the comforting Fed narrative would need to navigate two possible complications. First, how does an excessively data-dependent Fed declare an end to the hiking cycle when facing a developing upturn in inflation? Second, and more fundamentally, how should the Fed assess the trade-offs for the economy stemming from the risk of pressing too hard toward its stated 2% inflation target?
The bottom line is a simple one. The favorable CPI numbers for July, while highly welcomed, should not lead yet to a simple linear extrapolation for what’s ahead. The economy, the markets and the Fed still need to navigate what’s already in the pipeline from the handful of items that, more than two years ago, helped initiate the current inflationary episode.
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