Steady Buildup of Inflation Allowing Fed to Stay the Course

Today’s U.S. consumer inflation report didn’t trigger the same volatile response in the markets we saw from the U.S. producer inflation report on Wednesday, but nonetheless, it was impressive.
James Hyerczyk

According to the U.S. Labor Department, the Consumer Price Index edged up 0.1 percent as gasoline price increases moderated and apparel price fell. The CPI rose 0.2 percent in May, matching economist expectations.

The data extracted from the report showed that in the 12 months through June, the CPI increased 2.9 percent, the biggest gain since February 2012, after advancing 2.8 percent in May.

The Core CPI report, which excludes the volatile food and energy components, also rose 0.2 percent, matching May’s gain. That lifted the annual increase to 2.3 percent, the largest rise since January 2017, from 2.2 percent in May. The gain also matched economist forecasts.

The increase in both the CPI and Core CPI reports reaffirms the Fed’s preferred inflation measure. Recently the personal consumer expenditures (PCE) price index, excluding food and energy, hit the central bank’s 2 percent target in May. Given its current trend, the PCE is expected to overshoot the target.

One concern for investors is whether the Fed will allow inflation to overshoot the target and by how much. This is going to be the center of most of the debate moving forward. Due to the stubbornness in getting inflation to the 2 percent target, the Fed is trying to be careful to avoid slowing economic growth too much, while at the same time trying to prevent the economy from overheating.

At this time, the steady buildup of both consumer and producer inflation pressures should keep the Federal Reserve on a path of gradual interest rate increases.

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This assessment is being reflected in the financial markets on Thursday. With the Fed likely to continue on its hawkish path, U.S. Treasury yields are firming and this is helping to make the U.S. Dollar a more attractive investment.

Furthermore, the inflation reports reaffirm the divergence between the monetary policies of the U.S. Federal Reserve and other major central banks. For example, with the Fed hawkish and the Bank of Japan dovish, the interest rate differential between U.S. Government bonds and Japanese Government bonds continues to favor the U.S. Dollar. This is helping to spike the USD/JPY higher this week, putting a 113.00 handle in focus.

At the same time, the Fed’s gradual approach to raising rates is helping to keep the U.S. stock market rally alive. As long as the Fed maintains its steady approach, stock market professionals will have the opportunity to adjust to the gradually rising interest rates. Any sudden changes in the outlook for inflation that could force the Fed to be more aggressive in hiking rates, for instance, could be a rally killer. So far, however, the Fed has been right on its projections, allowing money managers to hedge inflation and interest rate risk.

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