CPI surprises again on the upside

The US Consumer Price Index (CPI) surprised on the upside for the third month in a row. There was nowhere to hide in the release with a majority of sub categories and sub aggregates posting worse numbers than expected. On a month-on-month basis both headline and core inflation, which excludes food and energy costs, came in at 0.4% which leaves short term trends in a different lane than the one that leads CPI to hitting the Federal Reserve (Fed)’s 2% target. The only consolation prize was a negative core goods inflation number that gives some hope that maybe goods disinflation is not entirely over.
 
Core services inflation was unchanged from February at 0.5% with Shelter inflation in particular showing little signs of budging. Although inflation in this all important component is markedly lower than the peaks, progress seems to have stalled at levels that are higher than those consistent with the Fed’s inflation goal. As opposed to last week’s labour market report , we do think that this CPI report does change the picture for the Fed. Chair Powell mentioned that they needed to gain additional confidence that inflation was in fact moving in the right direction in order for rate cuts to become a reality. Given this is the third report in a row that has surprised on the upside and that services in particular refuses to trend down, we cannot help but think that the chances of three rate cuts for this year in the US have decreased.
 
The aforementioned does not mean that inflation targets will not be hit or that we are now in a permanently higher inflation environment. Time will tell and there is a lot of uncertainty in economic forecasts at the moment, but we think chances of a large inflationary shock or a renewed upward trend is unlikely. Therefore, we would characterise current dynamics as a delay in inflation falling closer to target rather than a complete departure from the longer downward trend that began in July 2022. Although the US has shown resilience, there are signs of stress in certain parts of the economy, such as auto loans and credit card delinquencies data. Growth is forecasted to slow as the year progresses which should help manage inflationary pressures as well. 
 
Market reaction was brutal with US Treasuries selling off by close to 20 bps in the short end and by just over 10 bps in the long end as market participants price out rate cuts in the near term. European spreads held up reasonably well while US spreads suffered more with high yield and investment grade widening by 16 bps and 3 bps respectively at the index level. It is possible markets have a slight blip with prospects for rates cuts being priced out but ultimately if this is just a delay as we believe it is, we would wager market participants will use a sell off as a buying opportunity thereby limiting the extent of a sell-off in spreads. It is important to remain attentive though. If the inflation situation evolves in such a way that the Fed is not able to cut rates, in our minds the probability of a hard landing would start to increase. It would become more likely that something somewhere in the economy breaks. To be clear, we do not think we are at that point at this stage but it definitely pays to remain flexible and liquid to react to a change in the base case.