By Michael Every of Rabobank
Yesterday’s US CPI report was one of those market-moving blockbusters that underline why nearly all the people who like to pretend they know what is going on really have no clue. I include myself in that group too for having been swept away by the trend expecting a weak inflation number for August on the back of lower gasoline prices – though in my defense I have been warning “not transitory” for over a year, and yesterday specifically flagged that US CPI was only going back to 2% again in magical DSGE models, not real life.
Regardless, what we saw yesterday was a 0.1% m-o-m rise in headline CPI against expectations of a -0.1% print, so the y-o-y rate only declined slightly from 8.5% to 8.3%; and core CPI soared 0.6% m-o-m vs. 0.3% expectations to increase from 5.9% to 6.3% y-o-y. Despite the drop in gasoline prices, the contribution from rents (covered here many times before) soared; so did grocery prices; so did health insurance. Even the BLS’s new core core core measure, which takes out energy, food, shelter, and used cars and trucks was up further to well above 6% y-o-y. As Larry Summers put it via Twitter, itself in the headlines again for several reasons:
“Today’s CPI report confirms that the US has a serious inflation problem. Core inflation is higher this month than for the quarter, higher this quarter than last quarter, higher this half of the year than the previous one, and higher last year than the previous one. Median inflation used to be a favourite indicator for team transitory. This month it was at its highest ever reading. It is highly implausible that inflation will fall to 2 percent without unemployment exceeding 4.5 percent. Yet this is the most pessimistic view among 19 members of the FOMC. Dangerous group think. With core inflation running above 7 percent this month and likely, given rent behaviour, to remain elevated, I fear it is unlikely that a peak Fed funds rate around 4 will be enough to restore 2 percent inflation.”
Markets are indeed now pricing for a terminal Fed Funds rate of over 4.25%. Moreover, they are not just expecting a 75bps hike in September, but risks of 100bps!
That threat was underlined by Summers, who added: “It has seemed self-evident to me for some time now that a 75bps move in September is appropriate. And, if I had to choose between 100bps in September and 50bps, I would choose a 100bps move to reinforce credibility.” More importantly, the same message was echoed by the Fed’s Wall Street Journal whisperer, Nick Timiraos, who underlined yesterday’s data “clinches the case for the Federal Reserve to lift interest rates by at least” 75bps at its next meeting.
That is not what you call a timorous Fed response – and the market was understandably all the synonyms for the same as a result: fearful; apprehensive; faint-hearted; trembling; quaking; cowering; weak-kneed, etc. That’s what you get if you are long and wrong.
The Dow was down 3.9%, the most since June 2020; the S&P was down 4.3%; the Nasdaq was down 5.2%. US 2-year yields leaped 28bps intraday and closed up 18bps at 3.76%, the highest since 2007; US 10-year yields spiked 16bps and closed up 5bps at 3.41%. The DXY dollar index soared 1.4% on the day. And yet oil managed to hold its ground on news that the White House is considering refilling the Strategic Petroleum Reserve at $80 per barrel. Given what our energy analyst Joe DeLaura is forecasting in terms of prices, that would be a bargain. That is to say that even the current help to CPI from lower gasoline prices likely won’t last too much longer.
That backdrop will give Asian markets more than enough to chew, or choke, on today - in particular, let’s see how the PBOC tries to draw a new line in the sand on CNY: perhaps by building more houses on the same foundation? However, there is more to focus on than that in those terms. As Xi Jinping prepares to meet Vladimir Putin in Uzbekistan at the Shanghai Cooperation Organisation, which even Bloomberg points out aims to build ‘anyone but the West’ global infrastructure, potential geopolitical risks are flagged from the two leaders being seen as too close when everyone Western wants to be as far apart from Russia as possible.
Moreover, Reuters claims, ‘US considers China sanctions to deter Taiwan action, Taiwan presses EU’, saying the idea is to extend the Russia playbook and “take sanctions beyond measures already taken in the West to restrict some trade and investment with China in sensitive technologies like computer chips and telecoms equipment.” Some analysts suggest China's military could be the specific focus. However, given Beijing’s dual civilian/military use policy and the reality that, as in The Matrix, any civilian anywhere can become an Agent, that goal is either detached from reality, or implies a reality where we are detached - which would be highly inflationary.
Today also sees the EU’s State of the Union address: this year it could be titled “What a state of the Union!” Obviously, it has to explain to the public what Europe’s energy strategy is. Yes, we are now down 50% from the crazy peaks in gas and baseload electricity prices seen last month in very thin trading. However, we are still up 8-10 times from what was normal, and the most optimistic projections assume we stabilise around 5 times that. These are not energy prices at which normal economic activity can be sustained.
We are almost certainly going to see temporary levies on the energy sector to offset some of the massive cost of subsidies elsewhere. Yet while logical this does not leave capital to invest in new energy supply: where will that come from, if the EU is not to be held hostage again?
We are also going to have to see official rationing of energy usage, or “load shedding”: planned cut-offs to some sectors at some times to prevent the risk of random blackouts. The figure being floated is 5% during peak periods and 10% overall. That doesn’t sound like a lot – but would you like to lose 10% of your body? That’s what we are talking about in economic terms.
Simply, there will be massive knock-on effects across supply-chains, which is inflationary; and on employment, which is deflationary; and more strain on public finances, so upwards pressure on bond yields; or, if monetized, downwards pressure on the Euro, which would be inflationary.
Yet as we pick up the pieces from yesterday, and some might be shifting from 50bps to 75bps or from 75bps to 100bps from the Fed, many will still be updating their DSGE models to show an even higher near-term spike in CPI… and then the same magical return to 2%. Indeed, how many days or hours until we see headlines suggesting “the Fed doesn’t mean it,” or “the higher rates go up, the faster they have to come down,” or “it is still transitory if you look at (obscure object of choice)”?