Our view on inflation following the U.S. Federal Reserve's decision to hike interest rates by 75 bps.
Market volatility surged again across markets earlier this week as investors anticipated a greater likelihood of a large interest rate hike from the U.S. Federal Reserve (Fed) in order to ease inflation pressures. The Federal Open Market Committee (FOMC) concluded the policy-setting meeting held on June 14-15, 2022 and decided to raise interest rates by 75 basis points according to the FOMC statement following the meeting.
At Picton Mahoney, we have been monitoring the new inflation data very closely and are sharing our view on some new developments:
Core inflation: It seems to be decelerating, though not as quickly as we hoped. The strength is generally coming from core services (Fig. 1).
- Core goods prices are starting to turn into a headwind as evidenced by negative contribution of many durable and household goods.
- China Producer Price Index continues to decelerate as well, indicating that global price pressures for manufactured goods are dissipating.
- The supply constraints that led to goods inflation happened early in 2020 and were being mended in 2021. It seems to be better now, though it is not 100% back to normal yet.
- Core Services is accelerating and is the main problem – this is largely driven by labor shortages resulting in capacity constraints.
- This was less of a 2020 problem but developed in 2021 because of the second round of Covid lockdowns. After renewed lockdown cycles, service businesses did not fully re-open back to full capacity. They waited to see. Unfortunately, it is generally harder to find labor now to get back to full capacity. The situation may take time to resolve, but this is also a transient problem (i.e., not necessarily a cause of sustainable long-term inflation).
Wages: Because inflation is higher than wage growth, real wage growth is negative and consumer sentiment plunged again (Fig. 2).
- Demand almost always follows, but this time there is a lag due to the long tail of Covid lockdown pent-up demand. Lower demand will likely negatively impact prices in due course. Retail inventories (ex-autos) are already quite high, a sign that demand is waning.
Housing: Shelter was also a big and rising contributor to core inflation.
- There is evidence in Canada that home prices are already falling in response to higher interest rates.
- US housing sales/inventory ratio is in our view at a dangerous level (similar to 2005).
- The recent surge in mortgage rates and home prices has made the cost of carrying new homes in the US the highest it has been in decades (Fig. 3).
What is the Fed looking for?
The Fed hiked 75 bps now, but the “dot plot” suggests that another +200bps is expected over 4 meetings this year as they want policy to be at restrictive levels at the end of the year. They consider economic activity as improving after a weak Q1 2022. Fed Chair Jerome Powell sees the financial conditions tightening as “very healthy”.
The biggest change in the statement is this line: “The Committee is strongly committed to returning inflation to its 2 percent objective”. There were also big changes to the Summary of Economic Projections. Taken together, it seems like they are saying that they need to crush growth and employment in order to remain on target with inflation goals and are strongly committed to doing this.
In order to ease off the current tightening path, the Fed is looking for a "series" of declining monthly inflation readings. Also, they seem to be quite spooked by rising inflation expectations data recently and want to see that improve i.e., the University of Michigan long term expected inflation survey going from 3.0% to 3.3% (Fig. 4).
“The race is on between demand destruction and supply responses” is a good way to summarize it. We continue to monitor the situation extremely closely, and we are managing our strategies diligently, using our hedging and risk mitigation tools. For more information, please reach out to your Picton Mahoney sales representative.
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