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Inflation Peaks, But Fed Stays Hawkish

Last week delivered encouraging news on the US inflation front. Data across a range of inflation and related indicators suggest pressure is easing somewhat, even if the actual level of inflation remains near multi-decade highs. Risk assets rallied impressively in response. Pricing in the forward rates market became more dovish. The odds inferred from federal-funds futures for a 75bp hike at the Sept. 20-21 FOMC meeting are now just around 50%, down from around 75% at the end of the prior week.

The July CPI data was encouraging. Overall headline inflation didn’t rise over the month (consensus had expected an increase of 0.2%), and rose 8.5% on the year, compared to an annual increase in June of 9.1%. Much of this moderation occurred thanks to lower energy prices, which fell 4.6% in July. Indeed, core inflation (which excludes food and energy prices) was up 0.3% on the month and stayed at 5.9% on an annual basis.

The Producer Price Index also released last week actually fell by -0.5% on the month, adding evidence to support that idea that inflation may have peaked. Furthermore, the NY Fed Survey of Consumer Expectations indicated that both short- and longer-term inflation expectations declined in July, and the University of Michigan Survey also showed a decline in 1-year inflation expectations, although 5-10y expectations were higher on the month.

We may have reached peak inflation, but we don’t anticipate that it will fall very quickly. We’ve often pointed out that inflation was broadening across a range of stickier, less pandemic-affected categories, primarily in the core services bucket. These items tend to exhibit more inertia, meaning price increases are more likely to persist. The good news, as seen in the chart below, is that the annualized three-month percentage change was quite a bit lower in July, at 6.9% compared to 8.5% for the same measure in June. Still, these are high rates of inflation, and the deceleration in core services, which makes up 56% of the CPI basket (and 73% of the overall core index) may stall or occur very slowly.


The highlight as we start the week in Europe is the People's Bank of China's (PBoC's) decision to surprise with a 10bp cut to its MLF rate. This was last cut at the turn of the year and the move follows a weak batch of July Chinese data in the form of aggregate financing, industrial production and retail sales. Occasionally, one might see the commodity currencies rally on news of fresh monetary stimulus. In this instance, however, the Australian dollar is off around 0.5%. This can be rationalised through the view that the Chinese economy is still struggling and looks unlikely to contribute to any upside surprises to global growth this year.

At the same time, investors are wary of new Covid outbreaks amid China's zero-Covid strategy and the potential for the type of renewed lockdowns that triggered China's GDP contraction in 2Q22. The renminbi has softened on the news and with the PBoC clearly acknowledging the need for more stimulus, investors may start to speculate that the 6.80 ceiling in USD/CNY may not be as strong as it seems. Keep track of USD/CNH here, where any moves through 6.80 could provide some support to the dollar across the board - just as it did back in April this year.