Good news for markets as the Fed’s favorite inflation measure may have peaked

Federal Reserve Chair Jerome Powell, from left, Lael Brainard, US Vice Chair … [+] Federal Reserve, Federal Reserve Governor Philip Jefferson, and Federal Reserve Governor Lisa Cook, during an inauguration ceremony in Washington, DC, U.S., Monday, May 23, 2022. The Senate this month voted Powell for to confirm a second four-year term as Federal Reserve Chair and trust him to fight the highest inflation the country has faced in decades. Photographer: Al Drago/Bloomberg

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Today’s PCE inflation number was relatively good news for markets, suggesting that inflation could trend lower over the summer. The annual price change for April 2022 was 6.3%. That’s down from 6.6% in March, as goods prices rose at a slower pace than before and service price increases broadly picked up at a similar pace to recent months.

Excluding food and energy, annual inflation fell to 4.9%, a growth rate we last saw in December 2021. It’s too early to be sure, but inflation may be trending down. Of course, inflation is still well above the Fed’s target of 2%, but the direction is potentially positive.

The metric The Fed clocks

This is important as PCE inflation is a metric that the Fed is clearly watching and was mentioned seven times in the minutes of the Fed’s May 2022 meeting. These minutes also made it very clear how concerned the Fed was about inflation. The latest inflation data could allow for a slightly calmer stance at the next Fed meeting and perhaps a correspondingly less hawkish stance on interest rates.

Has inflation peaked?

Inflation is a relatively noisy month-to-month streak, and inflation remains stubbornly high by historical standards. However, today’s report suggests that inflation may have peaked provided there are no other major events such as disruptions in energy markets or widespread Covid lockdowns in China.

Having peaked in inflation was something the Fed was reluctant to say at their May meeting earlier this month, so if true, it could eventually lead to a rethink in their thinking. It will also take a few more months of data to confirm the trend, but those concerned that inflation may continue to rise from here can at least find some solace in the latest numbers.

CPI data

Also, separate CPI data for April 2022 told a similar story, with an abrupt deceleration in month-on-month price increases, with used cars and clothing falling month-on-month and energy series actually falling in price, remaining elevated but deviating from the extreme March highs.

If inflation falls, the Fed may have an opportunity to roll back some of the more aggressive rate hikes planned for 2022. That would likely be positive for both the equity and bond markets.

Currently, the Fed Funds rate is expected to shift from just under 1% today to closer to 3% by December 2022, according to futures markets. However, given the latest inflation news, markets are now viewing the more extreme rate hike scenarios as slightly less likely.

Prices are still expected to rise, but perhaps not quite as much and quite as quickly. According to most Fed watchers, a “double” 50 basis point hike remains on the cards next month, but after that expectations for the pace of interest rate hikes will begin to soften.

Good news for the markets

Overall, this is good news for the markets. Inflation concerns and the Fed’s likely response to them have been a key driver of the bear market for many stock indices in recent months.

Of course there is no fundamental reversal, we are probably still in an environment of rising interest rates for 2022, but perhaps some of the more extreme interest rate scenarios will become less likely once inflation has indeed peaked. Of course, we’ll know more once the May CPI data is released on June 10th. The Fed will see this ahead of its scheduled June 14-15 rate-fixing meeting.