US inflation nears the peak, but it will be a long slow descent

The US consumer price index rose 1.2% month-on-month in March, which leaves the annual rate of inflation at 8.5%, the highest rate since December 1981. Energy prices rose 11% MoM, led by gasoline, while food prices increased 1% MoM. Stripping these out gives core inflation of 0.3%MoM/6.5%YoY, which was weaker than the 0.5%/6.6% consensus forecast. This appears to have come as something of a relief for the bond market, with participants seemingly taking it as a sign that inflation pressures are peaking.

However, it is important to note that the core miss was due to just two components showing weakness. Used car and truck prices, which have a large 4.2% weighting within CPI, fell 3.8% while education costs fell 0.2%. All other core components posted solid gains with shelter (33% weight) increasing 0.5% and apparel rising 0.6% with medical care gaining 0.5%.

We think another small increase in the annual rate is possible next month, but we are hopeful that the peak in CPI is close. Mannheim used car auction prices are down 5.4% over the past two months so used vehicle prices should fall further in April, while as of yesterday, the national average gasoline price was down 5% from the 10 March peak of $4.33/gallon. Nonetheless, we can’t take anything for granted given the uncertainties over the Russia-Ukraine war and how this might impact commodity prices, while the Covid lockdown story from China continues to create huge problems for supply chains.

Moreover, the descent from 8.5%+ inflation is unlikely to be quick. This morning’s National Federation of Independent Businesses survey reported that cost pressures are the biggest issue for small businesses and, for now, they are able to pass them on to customers. A net (those responding that they would raise prices less than those saying they would cut them) 72% said they raised prices over the past three months, with a net 50% expecting to raise prices further. We haven’t seen this sort of pricing power for the small business sector before, as the chart below shows.

The tight jobs market where there are more then 1.8 vacancies for every unemployed person, suggests wage pressures will continue to build as firms compete for staff. As such, we see little prospect of an imminent decline in cost pressures for business.

Then there is the housing component. House prices have risen more than 30% nationally since the start of the pandemic, with demand fueled by massive fiscal and monetary stimulus while housing supply has remained limited. This has pushed primary and owners’ equivalent rents higher and there is still some upside to come in all likelihood.

It’s clear that the Fed will act aggressively to get policy restrictive in order to regain control of the inflation narrative. We look for it to raise the fed funds rate 50bp at the May, June and July Federal Open Market Committee meetings, and once the proposed quantitative tightening gets up to speed we think it will then move to 25bp hikes.

This will come with an economic cost. Higher borrowing costs, a strong dollar and a potentially fraught political backdrop as we head towards the November mid-terms mean that the US economy will face intensifying headwinds. With consumer confidence already beaten down by concerns over squeezed spending power and supply chain strains also acting as a brake on activity, we recently revised lower our 2023 GDP growth forecast markedly to 1.8% from 3%.

A weaker growth environment and a hopefully more benign geopolitical backdrop in 2023 will help to ease price pressures and inflation could fall more quickly through the second half of 2023.

We expect an interest rate peak in the first quarter of 2023 at 3%

We expect an interest rate peak in the first quarter of 2023 at 3%, but the average period between the last Fed hike in a cycle and the first rate cut has only been eight months over the past 50 years. Given this history and the prospect of weaker economic activity in 2023, we are forecasting 50bp of rate cuts before year-end 2023 as the Fed finds itself needing to move to a more neutral footing.