Fed To Outstretch The Consensus

US Inflation Expectations just rebounded sharply in March from 4.2% to 4.7%.

Consumer expectations are often a reliable indicator of the eventual CPI number. This is because consumers are very focussed on prices at the moment, and therefore are putting a lot of thought into their responses. Expectations are most often driven by what consumers are seeing in gasoline price movements.

There is a very real risk the market is under-estimating just how tight the entire pricing structure is across all sectors in the US at the moment. Which has significant implications for the global economy as the Federal Reserve continues to respond.

There is currently no elasticity between inflation and a rise in gasoline prices. Which now in turn move more quickly in response to global oil prices. The end result is an almost direct connection impact between crude oil prices and actual inflation.

We should therefore be very cautious that US inflation may be about to re-accelerate sharply. The annual rate may well step down again, but re-accelerating in the monthly data will be the Federal Reserve’s greater focus.

This is why the on-going discussion of when the Federal Reserve will cut rates, remains somewhat premature.

The only real question, remains just how high the Fed will go? The market has been pondering whether the Federal Reserve will raise rates again at its next meeting? When there is actually no doubt at all about this.

The Federal Reserve will raise rates by 25 points at this next meeting, and most probably will continue to do so at another 2-3 meetings. All through this tightening cycle the market has drastically under-estimated, got wrong, just how high rates would go. The suggestion here, is that the market continues to do so.

There could be a pause after a further 50-100 points in rate hikes, but the risk bias will continue to the upside should inflation re-accelerate as I expect it will prove to do.

Stock markets are not just about interest rates however, and this is where things get truly tricky. The US economy is clearly in a fresh stumbling phase. Inventories were up just 0.1% for the latest month following a sharp 0.6% drop previously. In fact, wholesale inventories are down 0.5% over the past three months and are down 12% over the year, We have also just seen US productivity have its biggest drop since the 1980s, falling 1.2% over the past year.

We had been seeing some stabilisation in a weakened US economy, but now, with risks of still higher inflation and Fed Funds Rates, there may be further moderation ahead.

Corporate earnings are stressed, as major companies continue to lay off workers in large numbers. This tells us these companies are not seeing a short term slow down, but something more worrisome. Especially, given the recent difficulty to find good staff in the first place.

Overall, the US economy is still slowing, the banking crisis is triaged for the moment, but inflation and rates will move higher against the consensus view.

The market is actually pricing only one last rate hike followed by significant rate cuts. Which means there is an immediate risk to the market, should the view expressed here be proven correct.

If in fact there is a significant stretching between the economic reality and the markets wishful thinking, then eventually, the current broad swinging sideways consolidation in equity markets will end with a thud.

Clifford BennettACY Securities Chief Economist

The view expressed within this document are solely that of Clifford Bennett’s and do not represent the views of ACY Securities.

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