Is the great inflation scare almost over? Or are we just warming up for the second chapter?
Markets and Federal Reserve officials are on edge as they try to figure out where prices are headed next and if 5% Fed funds are too high, too low or just right. The stakes are especially high in Wednesday's US CPI report as it comes just a few hours before the FOMC decision and the latest update to the Fed dot plot.
Ahead of the report, WSJ Fedwatcher Nick Timiraos highlighted that some Fed officials are likely to change their dots based on the data. They could show a consensus at one cut this year or (more likely) two.
Here is the simple version of what's expected:
- Headline CPI +3.4% y/y and +0.1% m/m
- Core CPI +3.5% y/y and +0.3% m/m
Markets will go far below the surface for this report in an effort to find out what's driving the rises and what's likely to linger or fade away. Bank of America is forecasting unrounded headline at +0.13% and unrounded core CPI at +0.30%. The small differences in rounding will make a difference in the market reaction but even more critical will be the composition.
Services less rent of shelter is an area the Fed is watching closely and that decelerated to +0.2% from +0.65% in April while rents and owners-equivalent rent held steady at +0.4%. The FOMC expects home-related inflation to cool quickly in the coming months as it's an indicator that lags badly and trackers more-current metrics of market rents, some of which are negative year-over-year compared to OER up 5.75% in April.
Another detail to watch is motor vehicle insurance. While only representing 2.9% of the CPI, premium hikes accounted for nearly half of the 4.9% y/y increase in CPI core services ex rent and OER and the last three numbers have been +0.9%, +2.6% and +1.8%. Rates are up 22% in the past year.
Market reaction:
I believe the market is increasingly comfortable with the idea of falling inflation and is starting to worry about faltering growth. Tuesday's $39 billion Treasury auction was a good example as bids were 2 basis points stronger than the market was expecting, despite the looming CPI risk. Ten year yields have also made a series of lower highs in the short and longer term.
That kind of setup suggests buying the dip in risk assets and selling the rip in the US dollar if the report is strong (particularly if the strength is due to housing or insurance again). On the flipside, be careful with an undershoot in headline inflation if it's entirely driven by energy as the market is skeptical of gasoline price volatility.
As a short-term trade, be careful as this report will be mixed in with the FOMC and real money will wait until the dust settles on Thursday to make a move.
