US inflation shock rattles markets and central bankers

The latest US inflation data is a blow to share and bond market optimists and central bankers around the globe.

Traders and analysts instantly ruled out any prospect of a March rate cut and halved the odds of one in May after America’s latest CPI data was released on Tuesday. There’s now only about a one-in-three chance of the Federal Reserve cutting the federal funds rate in May priced into futures markets.

The US sharemarket, where the S&P 500 hit a record of more than 5000 points only last Friday, fell heavily, and bond yields spiked after the headline inflation rate rose 0.3 per cent in January relative to December and was up 3.1 per cent year-on-year. The numbers are worse than they appear, given that they come off a high base: in January last year, the headline inflation rate was 6.4 per cent.

America’s higher-than-expected inflation rate has rattled Wall Street.Credit: Bloomberg

Ahead of the data’s release, the consensus expectation was for a CPI reading of 0.2 per cent on a month-to-month basis and 2.9 per cent on an annual basis.

The “core” inflation numbers – excluding food and energy costs – weren’t any better, with the month-on-month rate up 0.4 per cent and the year-on-year number 3.9 per cent higher.

While there are some eccentricities in the way the US calculates its inflation numbers – shelter costs, which generated about two-thirds of the increase, are particularly controversial, and there might have been a greater seasonal effect than the methodology recognises as companies raised prices to play catch-up for last year’s inflation – the data is clearly not goods news for households, investors or the Biden administration.

The ‘last mile’ of central bankers’ efforts to tame inflation rates might not be as smooth or as linear as many economists and market participants have been assuming

It is, of course, only one data point and the more pertinent number – the personal consumption expenditure index that the Fed tends to focus on – will be available before the end of the month.

It’s also the case that monetary policies work with long lags. The January data might – by making the Fed more cautious about reducing interest rates – produce a more pronounced and damaging slowing of the US economy than, with hindsight, was warranted.

It does suggest, however, that the “last mile” of central bankers’ efforts to tame inflation rates that surged in the post-pandemic environment might not be as smooth or as linear as many economists and market participants have been assuming.

Since March 2022, the Fed has raised the US policy rate from zero to a range of 5.25 to 5.5 per cent and has held it at that upper level since July last year.

If that isn’t sufficient to kill off inflation, force it down to the Fed’s 2 per cent target and clear the path for rate cuts, then it is reasonable to question whether, for instance, the Reserve Bank’s cash rate of 4.35 per cent will do the job when the inflation rate here, with a four in front of it, is higher than America’s.

Expectations in the US that were very bullish at the start of this year, when as many as six 25-basis-point rate reductions were priced into markets, have shifted abruptly. Now, while there’s still a long-odds prospect of a May cut, most of the attention has shifted to July.

On that basis, you’d probably also push back the first RBA rate reduction, if there is to be one this year, from expectations of a mid-year move towards the latter months.

What the US data shows is that while goods inflation is continuing to fall as the impact of the pandemic-era disruptions to supply chains disappears, services inflation is rising. That will embolden those within the Fed who have been talking down the prospect of rate cuts, arguing they want to see a broader moderation of price pressures than just headline inflation figures.

Some of the increase in services inflation might be related to the way shelter costs are calculated (the methodology is based on a hypothetical assumption that all homes in America are available for rent) and the lags before changes to market-driven rents show up in the data, but in an economy with a tight jobs market, solid growth and a booming sharemarket, it’s not that surprising that the inflation rate is proving stubborn.

The Fed chair, Jerome Powell, has said the pre-condition for rate cuts is more good data.

“It’s not that we’re looking for better data. We’re looking for a continuation of the good data we’ve been seeing,” he said after the central bank’s last policy-setting meeting.

While it might be true that one data point doesn’t make a trend, that’s not what he got, which is why financial markets responded as they did to the news.

‘It’s not that we’re looking for better data. We’re looking for a continuation of the good data we’ve been seeing.’

Fed chair Jerome Powell

Wall Street’s benchmark S&P 500 and the Dow Jones Industrial Average indexes each slumped about 1.4 per cent, with the tech-heavy Nasdaq index down 1.8 per cent. (For Elon Musk watchers, Tesla shares fell another 2.2 per cent to take their decline since late December to almost 30 per cent).

The yields on two and 10-year notes and bonds spiked by 11 and 13 basis points, respectively. The two-year yields are at their highest level since mid-December last year and have risen 27 basis points so far this month.

The prospect of US interest rates remaining high for longer saw the US dollar strengthen by 0.64 per cent against its major trading partners’ currencies. (The initial impact on the Australian dollar was a weakening from 65.31 US cents on Monday to 64.55 US cents.)

If the January inflation data isn’t a one-off, sharemarkets and bond markets are now vulnerable to further disappointment.

US financial markets have run up aggressively since late October last year – the sharemarket is up more than 20 per cent, and the benchmark 10-year bond yield has fallen nearly 70 basis points – on expectations that inflation would keep falling steadily and that interest rates would be cut regularly and substantially from early this year.

In markets priced for perfect outcomes – and the highly rate-sensitive big technology companies that have driven this market are priced for perfection – any material shortfall against expectations can have an exaggerated effect.

For the moment, with only a single data point and one that, while below expectations, is still consistent with a trend of a declining annual inflation rate, there’s sufficient doubt over the quality of the data to mute the markets’ responses.

If the personal consumption expenditure numbers due on February 29 were to buttress the CPI data, or there was another poor CPI number next month, we might see a somewhat more significant reaction.

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