The Fed remains far behind the curve on inflation and likely seals the prospect of another 75 bps tightening this month – possibly 100 bps.
June CPI came in stronger than market expectations, printing 9.1% YoY on headline and 5.9% YoY on ‘core,’ excluding food and energy prices. Various officials and forecasters had highlighted preemptively the potential for an upside surprise. But despite the warnings, today’s report still managed to surprise on the upside. Last month’s increases were broad based and came from energy and services, while food and goods inflation declined a bit on the month. For the average American the most visible form of inflation is gasoline prices, which increased 11.2% on the month, a dramatic increase.
Despite June’s upsetting headline increase, several items that drove prices even higher last month have already begun to decline. Chief among those have been gasoline prices, which should pressure the headline figure down from June’s peak. Yet, the core figure remains disturbing and items such as owner equivalent rent tend to be stickier and lagging and likely have further room to rise, thereby supporting core inflation in the months to come.
The Fed will continue to focus on core inflation, but the outstanding question is whether the Fed needs to see a reversion toward its 2% target, or simply a flattening of the increases in core inflation.
Treasury rates rose amid the likelihood of faster front-end increases from the Fed. Moreover, the curve inversions extended, with 2s/10s now in the mid-teens – levels not seen since 2007. Keep in mind it was the higher-than-expected CPI in May that likely led to a 75 bps increase, rather than the 50 bps hike that Fed officials had signaled. The market is now pricing in between 75 and 100 bps of tightening at the upcoming July meeting. It is clear to us that a 100 bp move is now on the table.
It is concerning that average real hourly earnings are down to the lowest level since the early 80’s at -3.6%. Despite wage increases, the average American is making less – this is the most important statistic to watch to discern potential political implications in the upcoming midterm elections.
The only way we can change the current narrative of an aggressive Fed, coupled with a poor risk asset backdrop, is to see a mellowing of the inflation narrative. Although headline inflation may ease in July thanks to slipping gasoline prices, core inflation is likely to continue pushing higher. While the markets may have priced most of this in already, this June print is bad enough to signal that there’s a bit more to do.