Markets Shrug Off Inflation Uptick, Anticipating Fed Rate Cut This Month

Markets Shrug Off Inflation Uptick, Anticipating Fed Rate Cut This Month  | Jul 15, 2019 12:03

Two measures of U.S. inflation came in slightly higher than expected last week, but market participants quickly decided that inflation remained in the “muted” category and will not deter the Federal Reserve from implementing the widely anticipated quarter-point cut in interest rates this month.

Investors are counting on a cut. All three major U.S. stock indexes—the Dow Jones, the S&P 500 and the NASDAQ Composite—closed at record highs on Friday.

Inflation Ticks Up

The consumer price index released on Thursday showed the biggest increase in prices in a year and a half in June once food and energy prices were taken out. This so-called core inflation rate was up 0.3% on the month and 2.1% on the year. Median forecasts were for 0.2% and 2.0% respectively.

Not such a big deal while investors were more excited about the administration’s decision to abandon its plan to curb drug rebates, which threatened to throw the drug industry into disarray. United American Healthcare Corp (OTC:UAHC) rose over 7% and powered the Dow Jones Industrials across the 27,000 mark for the first time.

The overall CPI, in fact, was up only 0.1% on the month in June and 1.6% on the year, compared to 0.1% and 1.8% respectively in May.

On Friday, the producer price index, a measure of wholesale prices, also came in slightly higher than expected. The PPI gained 0.1% on the month and 1.7% on the year, compared with forecasts of no change and 1.6% respectively. In any case, it was the smallest year-on-year gain in two and a half years.

The index had also gained 0.1% in May, but was up 1.8% on the year that month. So price gains are slowing down, just not quite as much as economists anticipated.

Forecast of CPI

Core PPI—again stripping out food and energy prices as well as trade services—was unchanged on the month in June after registering 0.4% increases the previous two months. The year-on-year gain was 2.1%, down from 2.3% in May.

In theory, the PPI is a forecast of the CPI as wholesale prices are expected to flow into consumer prices. It’s a rough measure, but to the extent that it holds, the CPI is also likely to show a slowdown in the next month or so.

Fed Focus

In point of fact, Fed policymakers don’t pay much attention to either of these inflation measures. They have decided that the personal consumption expenditures index most closely tracks the price increases people are dealing with.

This PCE index, which is released later in the month, generally runs lower than CPI/PPI. That index showed a 0.2% gain on the month for May, and 1.5% on the year, while the core PCE rose 0.2% on the month and 1.6% on the year.

Investors are not anguishing over any of this, however. Commentators slice and dice the data—apparel prices are up, energy prices down, and so on—but a rate cut is considered to be baked in.

Half-Point Cut Unlikely

The uptick in inflation does probably preclude the half-point cut some analysts were optimistically hoping for. It may also call a September cut—still prognosticated by Fed funds futures—into question.

Even in the unlikely event that the PCE gain would come anywhere near the Fed’s 2% target in the next month or two, policymakers have no need to cut rates now. They have said for some time that the target should be “symmetrical”—that is, there should be several months of overshooting 2% to balance the many months of undershooting.

Inverted Yield Curve May Be Key

The Federal Open Market Committee, which will meet July 30-31, will probably find the inverted yield curve a more compelling consideration than inflation. Yields on 3-month Treasury bills have been running higher than the 10-year notes for more than 30 trading days, a sign that recession is on the way within the next 12 months.

On both days of his congressional testimony last week, Fed chair Jerome Powell affirmed the Fed is ready to take action to sustain growth. It wants to bring those short-term rates back down below the long-term rates and cutting the Fed funds rate is the best way to do it.

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