Skip-Go?
By Stefan Koopman, Senior Macro Strategist at Rabobank
Even as the inflation crisis appears to be ebbing, markets remain highly sensitive to the narrative-shaping US CPI reports. The good news conveyed by yesterday’s edition is that US inflation continues to cool, as expected prior to the release. With a 0.1% m/m and a 4.0% y/y increase, which is the slowest pace since March 2021, the headline print was more or less in line with these expectations. Many of the 'one-off' price spikes of this inflation wave, such as in energy, food, used cars, or rent in new leases, are receding in the rear-view mirror and dropping out of the relevant comparison bases. Further deceleration is in the offing too, unless the June 2023 headline CPI number somehow surpasses the +1.2% m/m of June 2022. It suggests there is a good chance that inflation falls to a 3% y/y or an even lower rate next month before this tailwind dies down.
However, US core inflation has continued its six-month trend of essentially moving sideways, with monthly prints of around 0.4% or an annualized rate of 5%. There are, of course, numerous ways to slice and dice these data to fit a particular (more dovish) narrative. For example, one could exclude rents and consider only new leases or remove the prices of used cars from the index to create more palatable core inflation figures. However, a ‘standard’ core inflation of around 5% is simply inconsistent with a medium-term inflation rate of 2%. Despite these underlying improvements, which have occurred even with unemployment remaining near historic lows, this lack of indisputable progress will still concern the hawks on the FOMC.
The reading is unlikely to sway central bankers' decisions at today's meeting (see also below). The market-implied probability of an increase is now slightly below 10%, down from around 25% prior to the release, indicating that a 'Skip' is now the consensus. However, a subsequent ‘Go’ in July is now considered the more likely scenario with approximately 60% probability. In fact, short-term USTs faced broader upward pressure, as the 2-year note currently yields 4.65% due to traders scaling back expectations of near-term rate cuts – in line with our own expectations.
The move higher was also informed by a much larger jump in UK bond yields, with the 2-year rising as much as 27bp to 4.90%. That is the highest level in 15 years. It is somehow reminiscent of Autumn last year, with the big difference being that the market is currently seeking to price the BoE’s policy response to a supply-constrained labour market that leads to more persistent inflation, instead of having to deal with a policy gaffe-induced blow-up of LDIs. That being said, the UK could provide a valuable case study to examine how rate cycles will unfold when monetary policy lags behind macroeconomic conditions and fails to address the key sources of inflation.
Despite chronically weak demand growth since the pandemic, as highlighted by this morning's monthly GDP figures showing a meager 0.1% rise in the three months to April, to a level just 0.3 percentage points above the pre-pandemic level, the UK stands out in terms of its inflation dynamics. The labor market re-tightened sharply in that same period, surprising economists and policymakers who anticipated an increase in slack. Instead, the unemployment rate declined from 4.0% to 3.8%, with workers making use of their negotiating power. Regular pay growth reached 7.2% y/y - the highest growth rate recorded outside of the pandemic period. While that’s not enough to secure anything other than real wage reductions –real average weekly earnings are the same today as they were in November 2005!–, it does fuel concerns of persistent inflation. Our own interpretation of embedded inflation, based on the answers provided by decision-makers in the BoE's DMP survey, does indeed suggest that inflation is embedded at approximately 6.3%.
So even as the Bank of England was among the first of the large central banks to engage in rate hikes in late-2021, the UK’s inflation persistence means it will be among the last to complete its hiking cycle. While we don’t subscribe to the market pricing that rates could rise above 5.75%, suggesting there’s still 130bp of official tightening to come, our own once-hawkish forecast of a peak rate at 4.75% is likely to be overtaken by this inflationary reality as well. Significantly more policy-prescribed pain will be needed to ease these pressures, with higher-for-longer becoming the more likely path until something snaps.
