Inflation cools further, spurring optimism in markets
Summary
The latest CPI data showed a substantial drop in year-over-year inflation for the month of June, inspiring some risk-on sentiment in markets and bringing a “soft landing” into focus for the Fed.
Latest on inflation
The latest CPI reading showed year-over-year inflation at 3% for the month of June, down a full percentage point from the May reading of 4%. The decline was largely fueled by decreases in the prices of utilities and gasoline, as well as various food items. Excluding food and energy, the YOY change was 4.8% (down 0.5% from May’s reading). While the numbers are still higher than the Fed’s long-term target of 2%, they have fallen very far from last summer’s peak of 9.1%.
Interest rates: the path forward
The latest CPI reading is further evidence that the Fed’s continued monetary tightening is having the desired effect on markets. What’s more, the tightening has not yet introduced significant weakness to labor markets, as unemployment in the U.S. remains well below 4%. With inflation trending down and employment holding strong, markets are forecasting only one more rate hike from the Fed for 2023, with a very high probability it occurs at the July 25-26 meeting. The hope is that the Fed can stay hawkish enough to keep inflation trending downward while avoiding the recession that many forecasted for the latter half of this year. Forward rates dropped following the latest inflation data, but remain slightly higher than a few months ago when markets were expecting a more immediate dovish turn from the Fed.
Dollar weakens sharply
The U.S. dollar index dropped materially this week, driven in part by the latest inflation data. With countries around the world still in the prime of their battles with inflation, and foreign central banks continuing their tightening cycles, the dollar is not seeing as large a boost from expected rate hikes in the United States. The idea of a successful soft landing may further weaken the dollar, as risk-on sentiment grows and investors leave safe-haven currencies for riskier assets.
The week ahead
There are some important economic indicators on the way next week, including housing starts and retail sales. Markets will also pay close attention to any messaging from the Fed ahead of the upcoming FOMC meeting.
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