Another Disastrous CPI Report
I am in New York City this week and only have time for a quick reaction to this morning’s CPI report.
The June CPI report was a straight up disaster for the Fed. Headline inflation came in ahead of expectations at 1.3%, which translates into a whopping 17.1% rate at an annualized pace. But if that wasn’t bad enough, core inflation also came in high at 0.7%, reaccelerating to an annualized 8.8% rate:
It gets even worse, with supercore inflation remaining high at an annualized 8.7% for the month:
There was nowhere to hide in this report. Even though headline inflation will come down with gas prices, elevated underlying inflation is becoming stickier. This isn’t a surprise to us; we thought that services inflation would pick up steam and the ongoing passthrough from earlier price shocks would keep underlying inflation high for longer than expected. The Fed though has been caught flat-footed by the repeated upside misses on inflation and is scrambling hard to catch up.
With this report, we can’t ignore the possibility that the Fed steps up to 100bp at the July meeting. The Bank of Canada did exactly that this morning. The argument for 100bp is that it is too late to avoid a recession, so just embrace it. The argument against 100bp is that the Fed has kept the focus on 75bp or 50bp to dispel speculation that it would hike 100bp at the next meeting, that 100bp would induce additional unwanted volatility, at a certain point continued escalation is just reckless (creating a deeper recession than necessary), and unlike in June the Fed doesn’t have a new SEP to provide a framework to support the move.
That said, the Fed has put itself in a position where to maintain credibility on its intention to restore price stability it almost needs to find a way to escalate with each new bad inflation number. The question is what direction that escalation will take; either 100bp in July or signaling another 75bp for September. I think, and have been expecting, the Fed will opt for the latter option, but the risk is clearly weighted toward a 100bp move in July. We have a couple of days before the blackout period for the Fed to put any speculation of 100bp to rest (I don’t think the Fed wants to shift gears the weekend before the FOMC meeting again).
The situation underscores our position that the Fed’s reaction function is now “higher for longer” until inflation is clearly no longer a problem. This means the Fed does not intend to reverse course and shift to rate cuts until after a long period of low inflation, we think sustained monthly rates less than 2.5% annualized for more than one quarter and as long as two quarters. The Fed has been repeatedly surprised by inflation and will continue to fear upside surprises for long into the future. It also believes the costs of doing too little outweigh the costs of doing too much. The battle against inflation is a fight they can’t lose.
Bottom Line: I don’t see an off-ramp to a soft landing anymore. The deepening yield curve inversion is screaming recession, and the Fed has made clear it prioritizes restoring price stability over all else. Will the pain of recession cause the Fed to reverse course and start cutting rates before it has decisively won the inflation battle? At this point, the Fed is insisting such a reversal is not going to happen.