August’s US consumer price index (CPI) data overnight was mixed. Headline inflation rose more than expected from 3.2% to 3.7% owing to a rebound in energy prices. In contrast, core inflation eased from 4.7% to 4.3% as the chart below shows.
Federal Reserve Chair Jerome Powell. AFP.
Source: Bank of Singapore, Bloomberg.
We think the Federal Reserve will look through the jump in energy costs and focus on the moderating pace of core inflation. Though core prices rose 0.3% in August due to volatile airfares and persistent rents, healthcare and car insurance costs, there has been a clear step down in the pace of monthly core CPI increases over the summer. From December 2022 to May 2023, core prices advanced by a strong 0.4%-0.5% each month. In June, July and now August, the pace has slowed to 0.2%-0.3% monthly gains.
Source: Bank of Singapore, Bloomberg.
We thus expect the Fed to leave its fed funds rate unchanged this month at 5.25-5.50%. Officials can point to August’s payrolls and CPI to show rate hikes are slowing employment and inflation.
The Fed’s likely rate pause should ease pressure on bonds after 10Y Treasury yields made new highs at 4.35% as the second chart shows. However, the Fed is still set to keep its hawkish bias as core inflation remains well above its 2% target as the last chart shows.
Source: Bank of Singapore, Bloomberg.
We therefore think the Fed will keep fed funds at 5.25-5.50% until June 2024 until core inflation falls further towards 2%. Elevated interest rates are likely to push the US into recession and ultimately cause 10Y Treasury yields to fall back to this year’s lows of 3.25% over the next 12 months.
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