Post-Rate Hike, Market May Price Inflation Below 2%

Next week, the Federal Reserve's interest rate hike of 25 basis points is almost a foregone conclusion, and the market expectations are likely to undergo a dramatic change after the interest rate decision. Investors' focus will once again turn to this topic...

This is not a normal economic cycle. For policymakers, investors, or market traders, these years have been painful. Unprecedented shocks and soaring inflation have plunged the economic world into difficulty. For forecasters, the main challenge lies in trying to assess what the lasting trends in the market will be once the dust settles.

Forecasters are reluctant to accept that the post-pandemic inflation surge was merely a temporary repricing following global lockdowns and supply disruptions. They then turned to worry that energy turmoil related to Ukraine would prolong the squeeze on living costs for years and trigger a severe economic recession.

However, as the impressive disinflation in the United States swept through the entire year of 2023, with no significant downturn in employment or the overall economy so far, this narrative has shifted again, leading the market to predict that the Federal Reserve's aggressive tightening policy may also be short-lived.

With the term "soft landing" once again becoming the majority view, and phrases like "perfect disinflation" everywhere, it raises questions about whether the underlying price dynamics have changed significantly, even with the redrawing of geopolitical and supply chain maps.

"Is 'stickiness' the new 'transitory'?" Morgan Stanley strategists asked this week. They compared the Federal Reserve's previous "transitory inflation" view with the current belief that inflation is cooling down.

They believe that whether the term "stickiness" will disappear from the lexicon like the term "transitory" did at the end of 2021 depends on recent U.S. price trends and the important speech delivered last week by Federal Reserve Governor Waller.

Interestingly, strategists Gunneet Dhingra and Allen Liu believe that the Federal Reserve may again be "behind the curve" in judging how much the inflation rate will decline from its current level, just as many suspected two years ago when the Federal Reserve took measures to control the rise in consumer prices.

Like many others, they are focusing on the significant drop in used car prices. Used car prices are one of the main drivers of the core inflation rate, which currently stands at 4.8%, still far above the overall CPI of 3%.

Used car prices fell by 4.2% in June, coupled with surveys indicating further declines in the future, and the favorable low base effect from last year, the core annual inflation rate may fall below the "sticky" range of 4%-6% in the coming months, a range it has been in since the end of 2021.This could, in turn, satisfy Waller's condition that two more impressive inflation (cooling) data points are needed for the Federal Reserve to stop raising rates after an almost certain 25 basis point rate hike this month. Despite his warning last week that the June inflation surprise could be a one-time event.

Morgan Stanley's research team pointed out that the core inflation "revised average" inflation indicator, excluding high and low outliers, has been declining for four consecutive months. They suspect that the core inflation in June did not reflect the actual situation and believe that the disinflation in core CPI is more of "a trend, not an illusion."

They believe that with the increase in labor supply, the Federal Reserve may (and should) be less concerned about the strong job market. U.S. Treasury Secretary and former Federal Reserve Chair Yellen also expressed this view on Tuesday.

Neutral interest rates hide subtleties! The market may expect inflation to be below target.

Of course, some people are skeptical of this optimistic attitude.

Barclays analysts believe that the cooling of volatile items such as airfare and hotel prices may not be sustainable, and these data have contributed to the deceleration of core service inflation. They said that a tight job market poses questions for future progress.

They concluded, "We strongly doubt that the June data exaggerated the downward pressure on inflation."

A survey of global investors conducted by Bank of America (BofA) this month also seems to indicate that as the survey shows that the overall expectation of global inflation in the next 12 months has stopped falling, the good news about the decline in inflation may be coming to an end.

Despite the decline in the CPI index this month, the survey shows that fund managers are still overweight in bonds, with an overweight level more than two standard deviations above the long-term average.

Of course, this position is preparing for two potential scenarios. First, if the optimism about disinflation is proven correct, the Federal Reserve's tightening policy will end. Second, if the Federal Reserve continues to over-tighten, forcing the economy into a deep recession, Federal Reserve policy will shift.Considering Waller's assumed lag of interest rate hikes to be 9-12 months, the market's question is whether the Federal Reserve's tightening policies may not have had much effect yet, and there is a tricky issue of what the theoretically elusive "r-star" (neutral interest rate) should actually be.

Earlier this month, the U.S. Treasury market's 10-year real yield (that is, the yield adjusted for inflation) once touched the highest level of 1.839% in nearly 14 years, and the current real policy interest rate has exceeded 2%, both of which are far higher than the Federal Reserve's recent estimate of around 1.14% for the neutral interest rate.

Therefore, after the Federal Reserve further tightens policy this month, it is very likely to see the market begin to believe that inflation is actually below the 2% target, but it may also lead to a recession becoming a focus of market concern again.