After many consecutive months of higher-than-expected rises, the US CPI and core CPI in July 2022 finally both fell short of expectations, and the probability of a 75bp rate hike at the September rate meeting decreased. However, the inflation indicators closely tracked by the Federal Reserve show that underlying inflation is still rising. We believe that it will take at least two consecutive months to observe a downward trend in inflation before the Fed will recognize the change in the inflation pattern. Therefore, the possibility of raising interest rates to 4% this year cannot be ruled out.
Looking at the July inflation data in detail, the month-on-month drop in gasoline prices offset the increase in food and housing rents, and the month-on-month CPI growth rate was zero: gasoline fell 7.7% month-on-month (previous value +11.2%), food increased 1.1% month-on-month (previous value +11.2%) value +1.0%). In the first week of August, gasoline prices continued the decline in July, and the futures market expects this trend to continue this year, helping the CPI to gradually slow down.
However, the trend of the core CPI remains to be seen. Although its month-on-month growth rate slowed to 0.3% in July (the previous value was 0.6%), the year-on-year growth rate of 5.9% was unchanged from the previous month. It can be seen that there are still risks that the inflation will fall short of market expectations during the year. We believe that there are three main points:
First, housing rents are the biggest risk point for U.S. inflation exceeding expectations. In July, the year-on-year increase in housing rents expanded to 5.7%, and the month-on-month growth rate dropped by 0.1% to 0.5% (Figure 2). The S&P U.S. Home Price Index leads housing rents by about 15 months, and works backwards, with August-November 2022 corresponding to May-August 2021, when the S&P U.S. Home Price Index continued to jump until September 2021 The kinetic energy is weakened (Figure 3). As a result, the month-on-month momentum in housing rents may not weaken until December 2022 at the earliest, while the overall trending cooling in the housing market will not be reflected until mid-2023.
Furthermore, as an important part of core commodities (accounting for nearly 8% of the CPI), the downward trend in the price of vehicles is still unstable. Although the month-on-month growth rate of new car prices dropped to 0.6% in July (previous value 0.7%), the month-on-month growth rate of used car prices fell to -0.4% (previous value 1.6%). Given that the chip supply problem has not yet been fully alleviated and has been affected by the release of pent-up demand, the decline in vehicle price growth has not yet stabilized (Figure 4).
Finally, the month-on-month growth rate of wages is still picking up, adding to the stickiness of inflation. Average hourly earnings growth in the U.S. fell to 5.2% in July, less than we expected. Although the growth of wages in industries such as manufacturing and wholesale trade has slowed, the service industry, represented by the leisure and hotel industry, which has the largest increase, has not yet slowed down (Figure 5-Figure 6). The unemployment rate dropped to 3.5%, which confirms that the U.S. economy has not slowed down, which requires further action by the Federal Reserve to “cool down” the economy.
Our model shows that there will be challenges for core CPI to fall to 5% and core PCE to fall to 4% in 2022 (Figure 7). From this point of view, until the end of 2023, it will be very difficult for inflation to return to the Fed’s 2% target, and an anchor of 3% may be more realistic.
The decline in inflation has not yet formed a trend, and the possibility of the Fed raising interest rates to 4% this year cannot be ruled out. Our previous report referred to the current estimate of the neutral interest rate (0.3%) and the experience of the previous round of interest rate hikes (2015-2018), arguing that the current round of interest rate hikes will only last when the actual policy rate returns to near zero. will end (Figure 8). This means that if the core PCE is to fall back to around 4% this year, the Fed still needs to raise interest rates by at least 150bp to guide the actual policy rate to zero.
However, given that inflation data is more indicative than employment for the Fed to raise interest rates, we believe that the probability of a 75bp rate hike in September has declined. The August inflation data to be released before the Fed’s September 20-21 meeting on interest rates is crucial. If inflation continues to decline at that time, the possibility of a 75bp rate hike in September can be basically ruled out. To this end, we will continue to track the statements of Fed officials and the signals released by Powell’s speech at the Jackson Hole meeting on August 25-27.
As for when the pace of interest rate hikes will return to the normal of 25bp? Powell said at the July rate meeting that he would continue to raise interest rates until price gains slowed in a “convincing” manner. We believe that the CPI will continue to decline for at least 3 months before the Fed will recognize the change in the inflation pattern, and the discussion on the return of the rate hike pace to 25bp will not be until the November meeting at the earliest. Given that the pace of future interest rate hikes will be more dependent on economic data, it is still possible that the economic data released before the September meeting on interest rates will exceed market expectations, which will make the Fed’s choice to slow down interest rate hikes more difficult.
From the perspective of bond market pricing, the Fed’s approach of guiding real interest rates to rise is successful. Since the July interest rate meeting, the rise in 10Y U.S. bond yields has been mainly driven by the rise in real interest rates.
With reference to historical data, in the period when the Fed used interest rates as its policy target, the high point of the 10-year U.S. Treasury bond yield was often not lower than the high point of the federal funds rate, which means that the current 10-year U.S. Treasury bond interest rate level of 2.8% If it is too low, it is not a problem to rebound to 3% during the year.