It Will Take Much More Inflation Evidence to Impress the Fed Than Markets are Requiring

• Core CPI undershot expectations by a tick...

• ...and motivated a violent rally across the short-term rates complex...

• ...while pricing decent odds of a rate cut as soon as March & double the 2024 dots

• The FOMC is likely to set a higher bar for cutting than markets...

• ...as financial conditions are easing once again...

• ...and trend core CPI inflation is accelerating...

• ...and structural pressures remain notwithstanding short-term data noise

• US CPI / core CPI, m/m % SA, October:
• Actual: 0.0 / 0.2
• Scotia: 0.1 / 0.3
• Consensus: 0.1 / 0.3
• Prior: 0.4 / 0.3

US CPI inflation landed weaker than expected as shown in the table. That drove a violent reaction toward lower yields across the US Treasury curve and the fuller short-term rates complex with spillover effects across global benchmarks.

Markets are pricing no further hikes and a decent shot at a Fed rate cut by the March 20th FOMC date with most of a cut priced by the May 1st meeting. Over 100bps of cuts are priced by the end of next year into early 2025 which is double the 50bps guided in the September FOMC dot plot that also probably implied cutting late in the year.

THE FOMC WILL SET A HIGHER BAR FOR CUTS THAN MARKETS

My bias is that it will take a lot more than this report to motivate cuts that early especially after the Fed blew it on inflation’s upswing and is worried about resurrecting upside pressures, but we’ll see with more time and more data. I think it’s important to counsel more caution than what is implied by the violent swings in both directions that we’ve been seeing in fixed income markets for some time now.

Why? For one thing, core CPI inflation is still running at 2.75% m/m SAAR with a three-month moving average of 3.36% m/m SAAR. The Committee will need a lot more evidence of sustainably cooler on-2% core PCE inflation (not CPI) for an extended period before cutting.

For another, notwithstanding short-term noise in the data, there remain strong reasons to believe that structural forces remain pointed above 2% inflation.

Further, it’s possible that if this kind of market reaction persists, then we could go into the December FOMC with the Committee saying financial conditions have eased once again and inflation still isn’t where they want it to be while retaining a hawkish bias. Since the S&P’s low on October 27th it has risen by almost 10% and is approaching the highs set in July at a trailing P/E of 22 times and 1-year forward P/E of over 20. The US 10-year yield is about 55bps lower than the peak on October 19th and back toward late September levels. The 2-year is 36bps lower to about where it was in early September. The USD on a DXY basis is back to mid-September levels.

THE DETAILS

Core CPI landed at 0.23% m/m SA, or 2.75% m/m SAAR. That takes us back to the June/July period before the mild acceleration over August and September (chart 1). The three-month moving average of 3.36% m/m SAAR is the highest since June as this smoothed trend has moved higher.

The breadth of price hikes cooled but remains high (chart 2). Over 50% of the basket is rising by more than 3% and about half is up by more than 4% in y/y terms.

Both the goods and services sides of the picture contributed to the 0.2% m/m core CPI reading. Core goods prices (ie: commodities ex-food and energy) fell by –0.1% m/m SA (chart 3). Core services prices (ie: services ex-energy services and housing) were up by just 0.2% m/m SA which takes us back to the soft patch of readings we had over the April through July period before it accelerated in August and September (chart 4). You could say it’s just one month of cooling, or you could say July and August were the aberration—you pick, while markets have clearly leaned toward the latter interpretation.

Charts 5–15 show depictions of select components of the basket with select comments as follows:

• Housing inflation is defying earlier expectations for waning market rents to take it down by now, but maybe that just requires further patience. For now, we’re still left with very sticky owners’ equivalent rent and rent of primary residence.
• Vehicle price inflation has ebbed in terms of new and used vehicles and particularly the latter.
• Auto insurance premiums nevertheless continue to soar.
• Gasoline was a downside driver that explained much of the weaker headline CPI than core CPI reading. If the second half of November performs in similar fashion to the first half, then expect gasoline to be a downside driver of headline inflation in the next reading as well.
• Food-at-home (ie: mostly groceries) and food-away-from-home (ie: mostly dine-in, take-out, cafeterias etc) are off their peaks but still posting material gains.

Charts 16–17 show the fuller break down of the CPI basket in y/y terms both in unweighted and weighted contribution depictions. Charts 18–19 do likewise for the m/m break down. More detail is here.

Also please see the accompanying table that provides more detail by components including micro-charts and z-score measures of deviations from historical trends.