Inflation and an economic slowdown

We’ve just had an update on US inflation via July’s Consumer Price Index (CPI). Headline CPI, which includes food and energy, rose 8.5% compared to this time last year. This was below the consensus forecast of +8.7% which was in turn significantly lower than last month’s +9.1%. This was the first indication that inflation may have peaked, and we got another one the following day when Producer Prices also came in below expectations. While this is all good news, one month’s data doesn’t make a trend. Nevertheless, it was enough to give equities a significant boost, while the US dollar fell sharply. The probability of the Federal Reserve raising rates by 75-basis points at their next meeting in September fell from just under 70% to 40%. A 50-basis point increase is currently the most likely outcome, according to the CME FedWatch tool which calculates the odds using the fed funds futures markets.

Recession?

This CPI release rounds off a recent clutch of important market-moving updates. This began a few weeks ago when the US Federal Reserve raised rates by 75 basis points for the second successive month. That wasn’t a surprise, and the stock market rallied even as Federal Reserve Chairman Jerome Powell warned of further increases to come. But what did shock traders was the drop in GDP growth announced the following day. This was unexpected. It also means that the US is technically in recession, using the simple definition of two successive quarters of negative GDP growth. Now, it’s true that it’s the National Bureau of Economic Research (NBER) that officially decides whether the US is in recession or not. It takes unemployment and other factors into account, not just GDP. But we will have to wait months for confirmation, which rather spoils the effect. Of course, knowing if a country is in a recession isn’t particularly helpful for traders. The ‘technical’ definition doesn’t help, as quarterly GDP is one of the most backward-looking pieces of economic data around. In addition, the numbers are continually revised which is why the US needs a committee to rule on the issue. But by the time the NBER announces its decision, it’s quite likely that any recession will already be over.

Blow-out payrolls

Further complicating the situation were the latest Non-Farm Payroll numbers. These showed an increase of 528,000, way above the 250,000 expected. Also, there were upward revisions to the prior data. Putting all this together, US payrolls are now back to pre-pandemic levels having made back all the 21,568,000 jobs lost in early 2020. On top of this the Unemployment Rate dropped and is now hovering around 50-year lows. If the US is in recession, it’s got a funny way of showing it. But as more people go back into the workplace while GDP declines, then productivity must be falling. If that’s the case then there will be more downside pressure on growth.

Hiking into a slowdown

It does appear bizarre that the US Federal Reserve would be hiking rates aggressively in the face of an economy which, if not officially in recession, is obviously slowing sharply. But while investors are cheering the possibility that inflation has peaked, prices are still rising four times above the Fed’s 2% target. This requires higher interest rates. But higher rates will exacerbate the slowdown in economic growth. Yet unemployment is near record lows with plenty of vacancies in hospitality and healthcare, even if the tech sector is shedding staff. This would suggest that the US economy can deal with tighter monetary policy, although changes in interest rates act with a considerable lag. The Federal Reserve is clear that bringing down inflation is its number one objective, and to that end we should expect further rate hikes this year. But bond markets are also telling us something, and currently they predict that those hikes will be reversed out quickly as the economy continues to slow. As far as investors are concerned, there are some choppy waters to navigate. It’s more important than ever to stay nimble and alert.