CPI implications: pain or gain?
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CPI came in slightly hotter than expected today, at 3.7% y-o-y change instead of 3.6% (up 0.6% in August), mostly driven by higher oil prices (core inflation remained at 4.2%). This is now the second month in a row that inflation is picking up.
The most important question here is: what will the Fed do next week given this data read, and how will this be priced in?
A year ago, after Powell’s Jackson Hole triggered a 15% sell-off in SPX over the next month and a half (after which we reached the 2022 bear market low of 3500), we have witnessed a considerable shift in investor sentiment. Despite 300 bps of hikes after August 2022, the S&P went up 7.5% in total (from August to August), bonds did go down, but yields are still only 125bps higher than last August, and economic data - unemployment, GDP growth, etc. - is more or less unchanged. There hasn’t been any considerable pain to the economy caused by a pretty substantial interest rate hiking cycle. Apart from a month and a half correction back in Sep and Oct 2022, ever since 2023 we keep talking about a new bull market and a soft landing (or no landing) scenarios. There was a brief banking panic back in March, but its effects were regional and quickly absorbed by the bigger, much better capitalized banks, who didn’t suffer from unrealized bond losses (because they didn’t need to access the bond-held liquidity).
Why is that? Why haven’t rate hikes caused major economic pain over the past 12 months, as they did in prior historical episodes?
Many factors were at play but the most important one is that the real economy is still flush with cash. Consumers are well off, they have jobs, demand for labor is huge, so people can enjoy higher salaries and hence contribute to greater spending.
Yes, credit creation is in contraction, but firms aren’t yet feeling this burden as consumers keep spending. In other words, the demand side is heavily driving economic activity.
The huge fiscal and monetary stimuli from the COVID era caused a lot of damage. Inflation was the first obvious outcome (driven by the surge in post-COVID demand, primarily), but an even more worrying consequence is the reduction of potency of the monetary transmission mechanism. This is not such a big deal now, when things are going well for most people, but it will be when the economy will be in need of monetary easing. How much stimulus will we require next time a shock hits markets? Will rate cuts be enough? Because rate hikes clearly weren’t enough. And on top of all that, inflation is again picking up. Sure, it’s mostly energy for now, but it’s a worrying sign nevertheless.