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Why a not-so-swift decline in U.S. inflation would keep financial markets turbulent through 2023

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Of all the likely paths forward for U.S. inflation, there’s one with the most potential to catch many traders and investors wrong-footed throughout 2023.

It’s a path of not-so-swiftly decelerating price gains, which raises investors’ hopes of further easing in inflation but disappoints Federal Reserve policy makers counting on a faster return to more-normal levels closer to 2%. Such a scenario is already bearing out now after the past two months’ worth of data — in which the annual inflation rate of the consumer-price index fell to 7.1% in November from 7.7% in October after peaking at 9.1% in June.

Just three days ago, traders and analysts were describing November’s softer-than-expected CPI data, released on Tuesday, as a game-changer that suggested price pressures would ease quickly from here. It didn’t take long for investors and traders to realize such progress wasn’t good enough for the central bank, which hiked its main policy rate again on Wednesday, penciled in borrowing costs of above 5% in 2023, and warned that rates will likely be higher for longer.

“The market has been leaning against the Fed because it thinks the economy is slowing quite rapidly and policy makers won’t deliver on their promise to take rates higher,” said Gennadiy Goldberg, a senior U.S. rates strategist for TD Securities in New York. TD is deviating from the consensus expectations of markets by forecasting a fed-funds rate target that ultimately ends up at 5.25% to 5.50% by May, above the Fed’s 5.1% median estimate for 2023.  

“We’re thinking inflation remains sticky for longer than anticipated,” Goldberg said via phone. “A lot of that has to do with core services inflation, which has slowed, but not significantly declined, and the fact that you’ve had a very tight labor market for some time. From our perspective, the consumer is the driver for a lot of inflation due to low unemployment and high excess savings. The market is missing the fact that the economy is not slowing as much as the Fed wants it to,” he said, adding that TD sees no Fed rate cut occurring until next December.

Friday’s market action suggests investors and traders are starting to come around, however. All three major U.S. stock indexes appeared to be heading for back-to-back weekly losses, with the Dow Jones Industrial Average
DJIA,
-0.67%
down almost 500 points in afternoon trading. Meanwhile, Treasury yields were mixed as bond traders assessed this week’s central bank action in and outside the U.S.

Many investors have consistently underestimated the durability of inflation for more than a year, as well as the Fed’s resolve to contain it. While the Fed’s preferred inflation gauge is the personal consumption expenditures index, the central bank also pays attention to the CPI’s annual headline rate — which is still running at some of the highest levels in four decades — because of its impact on household expectations. As of this week, inflation traders were expecting the annual headline CPI rate to come in at or above 6% for December and January, before trailing off toward 2% during 2023.

One of the biggest factors that could keep U.S. inflation from easing meaningfully over the coming year, however, is a possible structural labor shortage in the U.S., in which the only way for companies to hire people is to pay higher wages, economists said. In addition, inflation could defy commonly held assumptions by remaining sticky next year even if the economy slows or falls into a recession, creating expectations for the Fed to begin cutting rates while “the Fed is saying no,” said Gregory Staples, head of fixed income North America at DWS Group in New York.  

“The inflation story is still very much up in the air,” said Derek Tang, an economist at Monetary Policy Analytics in Washington. “We have it coming back down to 2% in 2024, but the risk is that it comes down, just not quickly, which messes up how people price equities.”

“It’s not so much about the peak rate, but how long Fed officials wait before they cut rates again and whether they might actually start hiking again after a pause,” Tang said via phone. “Absolutely, 2023 is going to be volatile with all of these factors that aren’t clear, in which we don’t know when or how they are going to play out.”

 

 

 

 

Credit: marketwatch.com

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