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The Fed Needs To Show Markets Who's In Control of Inflation Expectations

Daniel Plainview

Updated: September 14, 2022

Inflation CPI
Editor’s Note:

EDITOR'S NOTE: A tricky conundrum for the Federal Reserve: if it takes around six months (at the earliest) to a year to see rate hikes work their way into the economy, then how might you know a year ahead of time that enough is enough? The Fed’s inflation expectations in 2020 turned out to be a real doozy. Its miscalculations caused it to badly overshoot its inflationary target. So, can we say that the odds of the Fed overshooting its target again, this time to the downside, would make for a reasonable wager? As the author states, inflation is expected to continue falling until the end of the year. But core inflation is stabilizing at the wrong levels. The Fed is aware of this, hence, its willingness to err on the side of hawkishness. But that also increases the likelihood of a nasty bear drop and, eventually, a deep and prolonged recession. So, are you hedged for the wallop ahead in which potentially trillions of dollars are knocked off the global GDP?

Inflation to fall to 8.1% in August from an 8.5% yearly rate in July, according to this group of specialized traders.

There’s a bit of good and bad news in the run-up to the next major U.S. inflation data on Tuesday, following July’s bigger-than-expected decline in the U.S. consumer-price index which triggered a short-term relief rally among stock investors.

The corner of financial markets with money on the line in getting the CPI data just right is expecting a continued drop in inflation for August and the rest of the year. Traders of derivatives-like instruments known as fixings now expect August’s annual headline inflation rate to be 8.1%, down from 8.5% in July. They also see the rate gradually declining to 7.7% for September, 6.9% for October, almost 6.4% for November, and 6.1% for December. The problem is that the decline still likely won’t be nearly enough to put an end to continued rate hikes by the Federal Reserve, or the market volatility that accompanies them.

Read: Inflation is slowing, U.S. August CPI to show, but not enough to mollify a worried Fed

The reason is that the number that matters almost as much as the annual headline CPI rate is the so-called core reading, which kicks out volatile food and energy prices, said Gang Hu, an inflation trader with New York hedge fund WinShore Capital Partners. By his calculations, headline inflation readings at these levels through year-end imply monthly core readings of 0.3%, or 3.6% on a 12-month basis.

“There’s been quite a bit of change after the last CPI report, and the market definitely sees readings that are a fair amount lower than where they were before,” Hu said via phone on Monday. “You could have a relief rally in bonds and equities if these numbers are realized, but I don’t think the relief rally is going to stay.”

“The Fed is going to hike 75 basis points next week, to above 3%. But core inflation is stabilizing around the wrong levels, and if you have inflation at 0.3% for the next three to four months, the job is not done and the Fed will have to keep going,” Hu said via phone. “We don’t know how much further the Fed will have to keep going or when is going to be enough.”

Hu isn’t alone in his views. Robert Conzo, chief executive and managing director of The Wealth Alliance in Melville, New York, which oversees $1.5 billion, said that while he thinks CPI is on a downward trend, the degree to which that happens and just how sticky inflation may remain is still unknown. Once those trends become more apparent, that will give the Fed a firm direction, he said in an email. And once the central bank’s rate-hike cycle ends is when investors will see the next big recovery in stocks, according to Conzo.

As of Monday, stock investors appeared to be somewhat optimistic. All three major stock indexes DJIA, -0.05% SPX, +0.06% COMP, +0.20% finished with their fourth straight session of gains, adding to last week’s gains. Treasury yields were mixed, though the policy-sensitive 2-year rate TMUBMUSD02Y, 3.779% was still at its highest level since November 2007.

Fed funds futures traders were pricing in a 67% chance that the Fed’s main policy rate target will get to between 3.75% and 4% by December, up from a current level of between 2.25% and 2.5%. And fixings traders are expecting an annual headline CPI inflation rate that eventually subsides to around 2.7% next July, but the truth is “the market doesn’t have much idea of what’s going to happen five months from now,” Hu said.

“The Fed’s concern is less about spot inflation. The big concern is about inflation expectations,” said the WinShore Capital Partners trader. “The Fed has to firmly control inflation expectations so spot inflation doesn’t completely change the view of inflation in society. Retail gas is coming down very quickly, but, on the other side, food and rent prices continue to go up. So the Fed has no choice but to show markets it’s in control of inflation.”

Originally published on MarketWatch.


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