May CPI is out this morning and the report will have repercussions for the market and to the Fed over the coming weeks. Following on the heels of Tuesday’s docile wholesale PPI report, today’s CPI release is another indicator that inflation pressures continue to be well-contained. The report will likely force the Fed to shift towards an easing posture at next week’s FOMC meeting. Overall CPI gained only 0.1% for the month matching expectations while year-over-year it edged down to 1.8%, below the 1.9% expectation and down from 2.0% in April. The average over the past year is 2.2% so the trend is definitely lower and away from the Fed’s 2% target. Meanwhile, core CPI (ex-food and energy) rose 0.1% for the fourth straight month and below the 0.2% forecast while the year-over-year gain slipped a tenth to 2.0%, missing the 2.1% expectation. In summary, the misses to the downside and tick down in both overall and core YoY results seem at odds with the Fed’s premise that the drift lower in inflation is just “transitory”. Predictably, Treasuries are rallying as the report should allow the Fed to move to an easing posture and start positioning for rate cuts. For more on that discussion read on below.
While the Fed has met the full employment part of its mandate, inflation continues to reside below the 2% target. With today’s CPI release the YoY downtrend that has more or less been in place since mid-2018 continues with core CPI ticking down a tenth to 2.0%. The Fed’s preferred inflation measure, core PCE, is currently at 1.6% and typically runs 30bps behind core CPI. Thus, with today’s release that implies a core PCE reading no higher than 1.7% when its reported on June 28, which is well after the FOMC meeting. Thus, today’s inflation read is the last prior to next week’s meeting.
With the market pricing in 75bps of rate cuts by year-end, the Fed has a couple approaches it can employ at next week’s meeting. For one, they can strike a defiant tone and point to unemployment running near their year-end projection of 3.7% and well below their 4.3% long-run rate they forecast back in March. That approach would likely lead to a material rally on the long-end as the market perceives a Fed about to embark on a major policy error.
The second, and more likely approach to us, is to recognize the global slowdown story, and increasing uncertainty stemming from the various fronts in the trade war, and strike a dovish tone that positions the Fed to cut as early as the July FOMC meeting. Today’s CPI report gives the Fed plenty of room to strike that easing posture as inflation pressures remain muted and still below the Fed’s 2% target. That should further the rally on the short-end while the long-end run may stall, but by no means does it imply an end to the rally that has been in place since November.
There is another option that might provide the most surprise to the market and that is to cut at next week’s meeting. While the Powell-led Fed has been fastidious in prepping the market for rate hikes should they take the same approach in a rate-cutting regime? One school of thought is that with less than 250bps of rate cuts to work with, one way for the Fed to get the most bang-for-the-buck is to surprise the market with a cut rather than grease the runway, as it were, and make the eventual cut a foregone conclusion and thus lose some of the element of surprise. While we don’t put that scenario in the most likely category it’s not out of the realm of possibility either. If there’s anything we’ve learned from the Powell Fed is that they are willing to shift stances rather abruptly when conditions warrant. So, suffice it to say if we were to get a cut next week we wouldn't be totally surprised.
Recall too that prior to the pre-meeting blackout period most of the Fed speakers didn’t push back on the market pricing in 75bps of rate cuts by year-end. Oh sure, there were voices that the economy was still in a good place and that policy seemed about right, but there wasn't vociferous disagreement to the markets fed funds futures positioning. That lack of pushback could be an open door to a possible June cut. We can imagine that a contingent would argue to wait until July 31st and thus get another month of data, but we can imagine too the dovish contingent proclaiming that if the next move is to be a cut, why not get on with it now? It’s an interesting take and one that might get a little more play over the next week.
Also, longer-run disinflationary trends allow the Fed to adopt an easing posture sooner rather than later. Dollar strength and China's yuan weakness are but two of many factors that will continue to work against any acceleration of inflationary pressures. Oil prices too continue to head south under the dual forces of reduced demand and additional supply.
Those pricing trends don’t appear to be reversing anytime soon and it’s a major reason that breakeven inflation expectations derived from the TIPs market remain in significant downtrends and that surely has the Fed’s attention (more on that below). The contingent that says to get on with a rate cut will probably use those charts of declining breakeven inflation trends to make their case. The market has priced in only a 21% chance of a rate cut in June while the July meeting is priced at 83%. Again, while prepping a market for a rate hike seems most appropriate should it be that way for a cut too? Perhaps not when one goes in with less than 250bps to work with.
Treasury Breakeven Inflation Rates Trending Lower
Treasury Inflation Protected Securities (TIPs) provide a useful gauge of investor sentiment towards long-run rates of inflation and it’s a measure that the Fed pays close attention. Because TIPs investors receive CPI-based inflation compensation, in addition to a modest coupon, the market pricing of TIPs provides a view of those investors’ inflation expectations. Those expectations have been in a steep decline since March and have been under the Fed’s 2% target since November 2018. This graph may be Exhibit 1 in the doves case to go ahead and begin rate cuts sooner rather than later, or run the risk that inflation expectations continue to head even lower.
Agency Indications — FNMA / FHLMC Callable Rates
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