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Core Inflation Surges, Increasing Headache for Fed

September 13th, 2022 -

About 3 Mins
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  • Headline inflation declined to 8.3% in August from 8.5% in July, but core inflation jumped to 6.3% from 5.9% in the prior month. The readings were worse than what economists and market participants had expected.
  • This almost ensures that the Fed would have to raise its Fed Funds Rate by at least 0.75% in its upcoming September meeting.
  • Equity markets declined sharply, short-dated bond yields rose, the U.S. dollar strengthened, gold declined, and cryptocurrency prices dropped after the report was released. Oil was down slightly.
  • Services inflation, and rent prices specifically, continue to remain elevated, while the price of gasoline declined significantly on a month-over-month basis.
  • The inversion in the yield curve increased from -21.8 bps to -31.2 bps. An inverted yield curve implies that the market expects a recession in the near future.

Inflation in the United States, as measured by the Consumer Price Index (CPI), advanced 8.3% from the year-ago period in August. This was a decline from the 8.5% year-on-year increase reported for July. The number was also above the 8.1% reading expected by economists. As a big negative for the Federal Reserve, core inflation, which is the headline number excluding volatile food and energy prices, was likewise worse than economists’ estimates, coming in at 6.3% versus the expected 6.1%.

Market reaction to the news was swift with equities falling sharply after yesterday’s gain, led by the Nasdaq down over 3%, the S&P 500 down 2.6%, and the yield on 2-year U.S. Treasury notes rising by a significant 16 basis points. The dollar also climbed, and Bitcoin rallied by more than 6%, briefly dropping below the $21,000 level. Gold, which has been historically viewed as a hedge against inflation, but has struggled thus far this year, also declined modestly to $1,717an ounce.

In one bit of good news, oil prices were down by 0.35% for the day and have fallen precipitously in the past two months. West Texas Intermediate, the benchmark oil gauge in North America, was the last trading at $87.55 per barrel, down from $122 per barrel in early June. This may mean that the headline inflation could decline moderately in September. The average price at the pump for consumers across the U.S. has dropped from a high of $5.02 per gallon in June, to an average of $3.97 per gallon in August, to $3.71 per gallon currently.

Electricity prices, in the meantime, continued to soar for the fifth month in a row, bucking the trend of lower energy prices. The electricity index rose by 15.7% due to the spike in coal and natural gas prices. Food inflation also remains elevated, thanks in part to the war in Ukraine. The gauge hit a more than 40-year high in August, climbing 11.4% on a year-over-year basis, and is going to pressure many lower-income households in the U.S. especially as wage increases have not kept up with the rise in prices. The shelter continues to be a problem as well, with rent prices increasing by 6.3% year over year.

Attention will now, therefore, turn squarely to the U.S. Federal Reserve System and the Federal Open Market Committee (FOMC) to see if the central bank would consider raising rates to 75 basis points or 100 basis points at its next meeting on September 21st. While the market was expecting a 75 basis points move in September before today’s report, the higher-than-expected headline inflation reading has shifted market expectations and futures are now implying a much higher chance of a 100 basis points increase.

Higher expenditures could pressure Americans’ ability to withstand the cost-of-living adjustments. This, ultimately, means a more aggressive Fed, which could mean a weaker job market, lower retail spending, curtailed home buying, and higher borrowing costs. Although consumer spending has been strong in the face of inflation, retail spending could experience more pressure on a forward-looking basis as borrowing rates, especially on credit cards, increase.

For the stock market, a stronger dollar, higher interest rates, and weakening demand are a trifecta of negatives. The stronger dollar is going to result in translation losses for the largest U.S. companies which generate a hefty portion of their revenue from international markets. Higher interest rates generally result in higher financing costs and lower valuation multiples. And weakening demand may pressure top-line growth and surging prices could weaken operating margins further.

This content is provided for general information purposes only and is not to be taken as investment advice nor as a recommendation for any security, investment strategy or investment account.

This content is provided for general information purposes only and is not to be taken as investment advice nor as a recommendation for any security, investment strategy or investment account.
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