The latest data for US inflation showed only a small decline. It was, however, enough to allay the concerns raised by stronger-than-expected data in the three previous US inflation reports. Bond yields fell and stock prices rose as markets viewed the glass of inflation as half empty meaning rate cuts remain on the agenda in 2024.
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Much-awaited data published on 15 May showed the US consumer price index (CPI) climbed by 3.4% in April from a year earlier, down from 3.5% in March. The ‘core’ index — which strips out volatile food and energy prices to give a sense of the underlying trend — rose by 3.6% in April, down from 3.8% in March.
Although only a modest fall, it was the slowest annual increase in core inflation since early 2021. As such, it provided considerable relief to markets, coming after three straight months of uncomfortably rapid US price increases.
Futures markets reacted to the CPI report by fully pricing in two rate cuts from the US Federal Reserve (the Fed) in 2024, having previously priced in between one and two cuts. US stocks set new peaks on the news, while yields of US Treasuries fell with the benchmark 10-year yield falling back to below the 4.50% level.
Only a small step in the right direction
On the day before the US CPI report was published, Fed chair Jay Powell warned the US central bank may have to keep interest rates higher for longer as it struggles to tame persistent inflation.
There was little evidence in the CPI report that suggests US inflation is going to come down to the Fed’s 2% target in the near term. The US central bank bases its target on the personal consumption expenditure (PCE) index, which most recently was up by 2.7% in March from a year earlier.
A lot more disinflation is needed
After incorporating the most recent US CPI and producer price index (PPI) data into their forecasts our macroeconomic research team suggests the April core PCE report could come out in a range between 0.2-0.25% month-on-month (MoM) equating to an annual range of 2.4-3%.
In our view, the Fed would likely want to see core PCE at no higher than 2.5% over several months and falling before embarking on a cycle of rate cuts. This will require a lot more disinflation.
Given the strong numbers in the first quarter of 2024, it would probably take a run rate of around 0.15% MoM for the PCE for the rest of the year for the Fed’s 2024 inflation forecast to materialise. That means we would need to see a mix of 0.2s and 0.1s from here on, without much interruption, for rate cuts to commence.
For this reason, our fixed income team expect only one rate cut from the Fed this year, in December.
US growth shaping up for a solid second quarter
The Atlanta Fed GDPNow model estimate for real US GDP growth (seasonally adjusted annual rate) in the second quarter of 2024 has fallen slightly. As of 16 May, it stood at 3.6%.
Weaker US economic data has been a theme in markets over the last few weeks. In the week of 13 May, housing and retail sales were lower than expected.
In the wake of this slight weakening, the market has now embraced the idea that US economic data is no longer so strong as to raise risks of the Fed having to increase rates, but the jury is out as to whether this is just a temporary soft patch or the start of something more serious.
Wait and see
The second half of May will feature much less US macroeconomic data than the first, so investors will need to be patient before there’s any significant change in the US macroeconomic narrative.
In our view, it would require a significant weakening of the US labour market for the Fed to begin cutting policy rates in the third quarter. The latest non-farm payrolls report showed 175 000 jobs were created in April. That was the slowest pace since October, but average job creation over the last three months has still been running at a strong level of almost 250 000.
It will require a weak US May non-farm payrolls report, due on 7 June, for the situation to change.
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