US interest rate cuts a question of when not if, Morgan Stanley says

Behind the headline US inflation figure there are enough clues for economists at three major banks to say the Fed will start cutting rates in July. That’s positive thinking for you.

As US inflation data exceeded expectations in recent months, the market trimmed the amount of US rate cuts implied this year. Picture: Spencer Platt / Getty Images via AFP

US inflation data looms as the next hurdle for global financial markets after Fed chair Jay Powell said fresh rate hikes are unlikely despite a lack of further progress on disinflation in recent months.

Thanks to Powell’s reluctance to lift interest rates, the dovish monetary policy implications of a weaker than expected April non-farm payrolls report, as well as better than expected US earnings reports, the S&P 500 has risen about 4 per cent, recovered almost all the ground it lost in April on worries about US interest rates and Middle East tensions.

The rebound in stocks came as Treasury yields hit their lowest levels in weeks amid renewed hope of US rate cuts, but yields bounced off key chart points last week amid more signs of sticky inflation, with the University of Michigan Consumer Sentiment survey showing a rise in inflation expectations.

As US inflation data exceeded expectations in recent months, the market trimmed the amount of US rate cuts implied this year to less than two cuts of 25 basis points versus three cuts projected by FOMC officials in March. The market also pushed out the timing of a first US rate cut to November.

At the start of the year the market expected rate cuts to start in March and almost seven cuts in total this year. Because US inflation data exceeded expectations for three months in a row, many think the Fed will need to see a number of lower inflation prints to get the “greater confidence that inflation is moving sustainably toward 2 percent” that it expects will be needed to cut interest rates.

Still, economists at major US banks including Citi, Goldman Sachs and Morgan Stanley believe the US economy will slow enough and inflation will ease enough that the Fed will be in a position to start cutting US interest rates in July.

Morgan Stanley says that regardless of the outcome of CPI data this week the bank will stay confident that US inflation will trend lower over the year, “making the question when, not if, the Fed will cut”.

“If our forecast is right, the April data on Wednesday will not represent a sea change,” said Morgan Stanley’s chief global economist, Seth Carpenter.

He sees core CPI inflation coming in at 0.29 per cent versus a consensus estimate of 0.3 per cent.

The data are expected to show a glacial decline in rent inflation, core goods prices falling a touch, and mild reversion of the upside surprise in services inflation.

“If we are wrong, the market will likely adjust the implied timing of the first cut earlier or later, but we do not think that the path for the year is likely to change much,” Carpenter said. “Where the signal is greatest, it points to disinflation. Where the data suggest upside risk, they are the noisiest.”

A key component to watch on Wednesday will be rents. Housing inflation comprises 40 per cent of core CPI and 18 per cent of core personal consumption expenditure inflation, so wherever housing inflation goes, the whole index will likely follow.

Carpenter points out that the Bureau of Labour Statistics takes current rents and essentially spreads those price changes over a couple of quarters. Current readings on rents have been very weak, so a continued fall in the official statistics for the rest of the year seems clear.

Despite the surge in immigration over last year and this year to date, he says that multi-family vacancies are approaching historical highs.

“In housing inflation lies the clearest signal for the path of inflation – and that path is lower,” Carpenter says.

As for the “lack of further progress” on disinflation in the past three months, he says that in the case of the personal consumption expenditure deflator, goods prices drove a lot of the increase, and computer software, video tapes, and apparel jointly explain two thirds of the acceleration.

Carpenter argues therefore that this inflation is “idiosyncratic, not widespread.”

Using the CPI weightings of those price categories, he finds that core goods inflation was negative for two of the past three months, with scope for more outright declines.

Supply chains have essentially recovered, the latest US GDP data showed an inventory correction, and China is focussed on investment and exports after over a year of deflation.

Carpenter does note that US services inflation outside of housing has also shown some inflationary pressures, with upside surprises in the past couple of months from portfolio management and investment advice components of financial services.

But he says these components are noisy and partly correlated to equity price swings, and he’s “looking for something of a payback”, given the S&P 500’s lacklustre performance last month.

Car insurance has been more consistently inflationary, but insurance companies are playing catch-up for the higher costs they faced in years past.

That impulse doesn’t reflect the current economy and is starting to fade on its own.

The general pattern is for one component to be strong one month and then weak in other months.

Also, Morgan Stanley’s US team recently showed that the seasonal adjustment has likely overstated inflation in the first quarter of the year, “suggesting some arithmetic payback later”. Taking all these factors together, inflation should fall over the year and when it does, the Fed will start to cut rates.