The Inflation Dragon Might Be Losing A Bit Of Its Fire

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The S&P 500 rose on Thursday to post its fourth consecutive record close as traders weighed more data showing that inflation pressures may be easing.

The broad market index eked out a 0.23% gain to end at 5,433.74, while the Nasdaq Composite advanced 0.34% to close at 17,667.56. Thursday marked the fourth straight closing record for both the S&P 500 and the Nasdaq, boosted by fresh data showing signs of cooling inflation pressures. May’s producer price index fell 0.2% from the prior month, while economists polled by Dow Jones had expected an increase of 0.1%. This report came a day after the Bureau of Labor Statistics posted consumer price index data for May that came in below the Street’s expectations.

Much to the market's delight, it seems the inflation dragon might be losing a bit of its fire.  

However, skewered by past mistakes, the Fed hesitates to signal the all-clear, pencilling in only one rate cut for the year. While their colleagues at the European Central Bank and the Bank of Canada eagerly hit the rate-cut button last week, the U.S. finds itself in a different boat. Growth is more robust, and the effects of tight monetary policy might be trickling through the economy at a snail's pace. Unlike in the past, the U.S. financial system leans less on bank lending. Many homeowners are comfortably insulated from the rapid rate hikes of 2022 and 2023, having locked in ultra-low rates on 30-year fixed-rate mortgages—an anomaly compared to their global counterparts.

This cautious stance by the Fed is understandable. After all, nobody wants to repeat past blunders. While the ECB and the Bank of Canada seem to enjoy their rate-cut party, the Fed is like the cautious neighbour peeking over the fence, waiting for the right moment to join in. It’s a tricky dance, balancing steady growth with cautious tacking, and so far, the Fed is sticking to its slow and steady approach.

Slow isn't the market's favourite sailing speed—especially when the producer price index, which shares the same methodological DNA as the core PCE data, suggests rate cuts could come as soon as September. Investors eagerly await the Fed to hoist their main sails and pick up the rate cut pace, hoping their preferred inflation gauge signals rate cuts and smooth sailing ahead.

A day after handing markets a wonderfully benign " Gift Wrapped" CPI report, the Bureau of Labor Statistics (BLS) doubled on the good news, revealing that producer prices fell in May, defying economists who had collectively expected a slight uptick.

The 0.2% decline, the second drop in three months, was driven by the largest month-to-month decline in goods prices since October. The services gauge, meanwhile, remained unchanged. The ex-food and energy gauge was flat from April, against expectations for a 0.3% increase.

The PPI  show's star was the energy gauge, which fell nearly 5% month-over-month, thanks to an even larger plunge in the gas index. That accounted for 60% of the decrease in goods prices.

Coming on the heels of the best CPI report of the pandemic era, Thursday’s release should have been the rate cut icing on the proverbial cake. The year-over-year PPI final demand print, at 2.2%, was well below the 2.5% economists had expected. Still, the not-so-dovish September rate cut read-through hiding in plain sight is that the Fed focuses on core inflation ex-energy ( more on that below) 

Meanwhile, initial jobless claims jumped for a third week. The 13,000 increase was among the largest of 2024, with the print hitting 242,000—the highest since August. The four-week moving average, at 227,000, was the highest since September. Continuing claims also topped estimates, reaching 1.82 million, the third-most since November 2021.

Last year, both the Fed and many private-sector economists foresaw a decline in inflation, as is often expected in a higher-interest-rate environment where economic growth tends to slow down. However, everyone, including the Fed, was caught off guard as economic expansion unexpectedly accelerated instead.

Earlier this year, just as officials hinted at potential "insurance" rate cuts, progress on controlling inflation hit a roadblock, delivering a sharp reality check to the market.

The Fed's trust-but-verify approach now finds them in a precarious spot. Powell and his colleagues are holding back, awaiting more compelling evidence that their current interest rate stance is sufficiently restrictive. However, this cautious stance also raises the spectre of reacting too late to prevent a more severe downturn in employment—an issue Powell acknowledged during Wednesday's remarks.

Unfortunately, this introduces an element where bad news could spell trouble as investors begin factoring in recessionary risks. In their calculations, investors must now, at minimum, consider the recession risk of the Fed delaying rate cuts for too long.

Revisiting the energy component of the PPI equation, the Fed's preference to sideline food and energy prices in its inflation analysis reveals an interesting paradox. While they aim to focus on core inflation measures excluding these volatile categories, they inadvertently rely on energy prices to assess broader economic trends. Jerome Powell and other Fed members underscore the importance of monitoring inflation expectations, which are heavily influenced by energy prices. This reliance on expectations, shaped significantly by energy costs, highlights a notable contradiction in the Fed's strategy—attempting to overlook direct energy price fluctuations while acknowledging their profound impact on inflation forecasts.

In essence, the Fed's approach resembles trying to ignore the elephant in the room while being tripped up by its tail—an ironic twist in their inflation monitoring framework.

More By This Author:

A Gift-Wrapped Box Of Inflation News
Throwing Caution To The Wind?
The Economic Data Is As Clear As Mud

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