The August CPI numbers came in yesterday and shook the financial markets. S&P 500 and NASDAQ plunged more than 4% and 5% respectively. The year-on-year (YoY) CPI fell to 8.3% from 8.5% a month ago, but on a month-on-month (MoM) basis, it rose 0.1%. Similar to July, a large decline in gasoline and fuel prices is what held the CPI down. But otherwise, almost all other categories rose (read the CPI press release).
While this does not suggest inflation is surging back to its July peak, it does indicate the problem is possibly stickier than thought. Before the numbers were published, the consensus expectation is a more optimistic scenario where YoY CPI come down to 8.1% with MoM CPI declining by 0.1%.
This mismatch in expectations wreaked havoc, especially on the stock markets which had been rallying strongly for the past few days. If you follow the market recently, this looks similar to what just happened right before Jerome Powell pumped up the central bank's hawkish tempo during Jackson Hole. That also triggered a massive selloff.
Where Are The Fed Funds Rates Pointing Now?
It will probably take a while before markets fully digest the data. But in the meantime, there is a fair bit of change to the expected Fed Funds Rate till the end of this year from a month ago.
After the jolt from the CPI figure yesterday, the markets no longer entertained the possibility of a 50 bps increase. It is deemed too low. And not just that, it is pricing in a non-trivial probability of a full percentage point hike (100 bps). At this point, it is 68% chance for a 0.75% hike and 32% chance for a 1% hike.
If we look at the path of the expected Fed Funds rates till the end of the year, we can see a marked increase against the August expectations. Based on what the data suggest, the likely path might be 0.75% for September, 0.75% for November, and another 0.25% for December. That brings the expected year-end Fed Fund rate to 4.34%. This is about 0.6% (more than 2 additional quarter-point hikes) higher compared to a month ago.
Some Thoughts About This
The stock market has been see-sawing between extremes this year. It is like a big fight between the buyers and sellers (and shorters). It is hard to glean much from it. But these wild swings are likely going to persist for a while.
These movements may be a result of our extraordinary position in the economic cycle. We have high inflation, an increasingly hawkish Fed, and a technically contracting economy as indicated by the declining GDP over the past 2 quarters. Under normal circumstances, we would expect the labor market to slump. But yet, the labor market is bucking the trend and remains exceptionally strong. Corporate earnings have also broadly so far been better than anticipated. In addition, inflation expectations are also supporting the narrative that inflation may have peaked or at least in the near term. These developments may have bolstered hopes of a soft landing where things would not turn out to be as bad as thought. Stock markets probably took that to mean that Fed may lift its foot off the pedal sooner.
So will we see a 1% this month? While I don't think we will go there and at the moment the probability is still on the low side, I have learned the hard way in the past to respect what the markets say. The Fed Funds futures will be the guide and we will know the outcome soon.
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