The most politically-incorrect word in economics is back. Mentions of “transitory” inflation have come into vogue again after yesterday’s data showed headline prices were unchanged in July after rising every month for the last two years, with the core measure also rising by less than expected. Market participants are increasingly convinced the Federal Reserve will slow the pace of hikes, lowering long-term rates and making monetary conditions more accommodative.
Last week’s tightening in financial conditions has largely reversed, with yields back to pre-non-farm payrolls levels and the dollar dramatically weaker against most of its major rivals. The greenback slipped as much in 1.6 percent in yesterday’s trading, and is struggling to gain traction this morning as risk appetites return and equity indices prepare to move further into bull market territory.
Crude prices are rebounding, with the West Texas Intermediate benchmark changing hands for $92 a barrel this morning, after falling into the mid-$87 range earlier in the week. The American Automobile Association said average US retail gasoline prices dropped below $4 a gallon yesterday for the first time since early March – a development that could help lift demand and put renewed pressure on inventories.
But soaring valuations could prove unsustainable. We do think inflation has peaked, yet the core consumer price index, which more closely aligns with the core personal consumption expenditure measure — the Fed’s preferred inflation benchmark — held at 4.7 percent year-over-year last month. Policymakers have said they want to see “compelling evidence” that price pressures and economic growth are cooling before they change course, and several Fed officials, including Daly, Evans, and Kashkari have already suggested that yesterday’s print won’t slow the central bank’s tightening campaign in the near term.
Hawkish jawboning efforts are likely to increase as policymakers try to reverse a persistent loosening in financial conditions. Hints of a more aggressive posture could come in any of a range of interviews, or next week’s minutes from the Fed’s July meeting, the following week’s speeches at the Jackson Hole conference, and the September “dot plot” summary of economic projections.
Gains in the euro are already reversing. The common currency surged in the initial reaction to yesterday’s inflation data, but a deceleration in US prices is of cold comfort to Europeans facing a surge in energy costs. With countries across the bloc taking steps to shore up their economies in preparation for a potential total shutdown in Russian oil and gas supplies, few expect the European Central Bank to match the Fed’s hiking trajectory.
The Canadian dollar is essentially flat, reflecting a drop in bets on a 75 basis-point hike at the Bank of Canada’s September meeting. As a small, open economy, the country is fundamentally a price-taker in global markets, meaning that US inflation pressures often pass directly through into domestic fundamentals – if a peak has been reached in the US, one will soon come to Canada. Yield differentials at the two- and ten-year horizons continue to favour the greenback, marking a reversal from loonie-supportive terms earlier in the year.
Prices paid by suppliers are thought to have grown more slowly in July than in the prior month. The headline producer price index, due for release at 8:30 am, is expected to show a 0.2 percent month-over-month increase, down from 1.1 percent. Investors see the less-volatile core measure rising 0.4 percent, at the same pace recorded in June.
Jobless claims could grind higher, rising to 264,000 in the week ended August 6. Data set for release at 8:30 am might illustrate a slow erosion in labour market conditions as the four-week moving average ticks upward.
Mexico’s central bank is expected to deliver a second consecutive 75 basis-point hike. The Banxico previously telegraphed an increase that would lift the target rate to 8.5 percent, and yesterday’s domestic inflation report — which showed an 8.15 percent year-over-year increase in headline prices — likely clinched the deal. As my colleague Karthik observed on the weekend, Mexican policymakers seem intent on keeping the dollar-peso interest differential at stable levels, implying that the benchmark rate could climb to 9.5 percent by year end if the Fed keeps tightening.